Benefits and limitations of financial ratio analysis in practice

Ratio and Financial Statement Analysis

The purpose of this essay is to critically analyze the benefits and limitations of 'Ratio and Financial Statements Analysis', explaining which factors impact on the meaningfulness of the financial ratio analysis; and establishing the new practices or theories that may be emerging regarding the application of ratio and financial statement analysis.

The essay covers 'Ratio and Financial Statements Analysis' with a critical analysis of the benefits and limitations of ratio analysis; it explains the factors that impact on the meaningfulness of such measures. In between, the essay outlines and explains the four stages of financial statements analysis. More so, the essay explains CAMEL as a new practice or theory that may be emerging regarding the application of 'Ratio and Financial Statements Analysis'. Consequently, it emphasizes the practical applications and real-world use of ratios. Besides, all references that have been used are less than 3 years old.

Finally, I have given personal recommendations pertaining 'Ratio and Financial Statements Analysis' just after a conclusion.

Definition Advantages and Limitations of Ratio and Financial Statement Analysis

According to the University of Windsor (2010), financial ratio and statement analysis is one way to analyze a company's financial performance. It looks at the relationship among elements contained in the financial statements. It is usually used to analyze a company's performance history, to compare a company to specific competitors, or to compare a company to its industry. Sooper Tutorials (2009) declares that financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements. The level and historical trends of these ratios can be used to make inferences about a company's financial condition, its operations and attractiveness as an investment.

Accordingly, Sooper Tutorials (2009) claims, financial ratios are calculated from one or more pieces of information from a company's financial statements. Sooper Tutorials gives an example of the "gross margin" whereby it declares that it is the gross profit from operations divided by the total sales or revenues of a company, expressed in percentage terms. Besides, Sooper Tutorials (2009) declares that in isolation, a financial ratio is a useless piece of information; and that in context, however, a financial ratio can give a financial analyst an excellent picture of a company's situation and the trends that are developing.

De Mello-e-Souza and Awasthi (2009) declares that financial statement analysis involves exploring a company's numbers in search of explanations for past performance as well as telltale signs about the future. Like a detective, the analyst is seeking the key to unravel a mystery or patterns to help organize a vast array of numbers. De Mello-e-Souza and Awasthi further claim that financial statements are typically analyzed in four stages: (1) preliminary data adjustments, (2) ratio analysis, (3) assessment of accounting quality, and (4) valuation. Hence, De Mello-e-Souza and Awasthi (2009) examines each of these in turn as follows:

(1.) Preliminary data adjustments:

In data adjustments, financial analysts seek to minimize measurement errors by converting financial statements to a common set of accounting rules, recognizing off-balance-sheet items, and distinguishing between necessary and superfluous assets. Standard adjustments include separating transitory from recurring items and distinguishing financing from operating effects. More-complex adjustments include capitalization of operating leases, capitalization of Research and Development (R&D) expenses, and consolidation of subsidiaries accounted for under the "equity method" (De Mello-e-Souza and Awasthi, 2009).

(2.) Ratio analysis:

Ratio analysis involves using ratios of financial statement and market-based numbers to examine companies over time and to compare them with each other in terms of profitability, efficiency and risk. An obvious weakness in ratios is that they presume linear, stationary-parameter, single-equation models of a firm. The advantage of ratios lies in their simplicity and in their power to generate important questions in short order. A good way to understand the story numerous ratios have to tell is to organize them according to the DuPont Model, as follows: Level 1 disaggregates business value in terms of growth, risk, and return on equity; Level 2 explains return on equity as return on assets plus financial leverage; Level 3 looks at return on assets as profitability of sales times asset turnover; Level 4 explains profitability of sales via common-size analysis of income; Level 5 explains asset turnover via turnover ratios for specific assets (De Mello-e-Souza and Awasthi, 2009).

(3.) Accounting Quality Analysis:

Accounting quality is associated with how well a company conveys its performance and financial position to investors by means of accounting reports. Since historical performance is often indicative of prospective earnings, accounting quality is associated with the degree of linkage between changes in reported income and changes in value. Accounting quality is a key concept for executives responsible for certifying that financial statements are "fair and true" and for financial analysts and management accountants who rely on these numbers to make recommendations (De Mello-e-Souza and Awasthi, 2009).

(4.) Valuation.

Financial forecasts supported by the three prior stages lead to fair value estimates. Significant gaps between fair values and market prices hint at important differences between what management and investors expect. Such differences can cause significant losses to investors and may lead to legal action against the company and its executives. Therefore, a thorough analysis of any gaps between market prices and fair values is an indispensable step toward relevant, fair, and transparent disclosures (De Mello-e-Souza and Awasthi, 2009)

In addition, Universal Teachers Publications (2010) defines ratio analysis as one of the techniques of financial analysis to evaluate the financial condition and performance of a business concern, that is, the comparison of one figure to other relevant figure or figures. Besides, Universal Teachers Publications claims that there are various groups of people who are interested in analysis of financial position of a company. They use the ratio analysis to workout a particular financial characteristic of the company in which they are interested.

Advantages of Ratio and Financial Statement Analysis

Therefore, Universal Teachers Publications (2010) outlines and explains that ratio analysis helps the various groups as follows:-

1. To workout the profitability: Accounting ratio help to measure the profitability of the business by calculating the various profitability ratios. It helps the management to know about the earning capacity of the business concern. In this way, profitability ratio show the actual performance of the business

2. To workout the solvency: With help of solvency ratios, solvency of the company can be measured. The ratio shows the relationship between the liabilities and assets. Incase of external liabilities are more than that of assets of the company; it shows the unsound position of the business. In this case the business has to make it possible to repay its loans.

3. Helpful in analysis of financial statement: Ratio analysis helps the outsider just like creditors, shareholders, debenture-holders, bankers to know about the profitability and ability of the company to pay them interest and dividend, among other payments.

4. Helpful in comparative analysis of the performance: With the help of ratio analysis, a company may have a comparative study of its performance to the previous years. In this way, company comes to know about its weak point and be able to improve them.

5. To simply the accounting information: Accounting information: Accounting ratios are very useful as they briefly summarize the results of detailed and complicated computations.

6. To workout the operating efficiency: Ratio analysis helps to work out the operating efficiency of the company with the help of various turnover rations. All turnover ratios are worked out to evaluate the performance of the business in utilizing the resources.

7. To workout short-term financial position: Ratio analysis helps to workout the operating efficiency of the company with the help of various turnover ratios. All turnover ratios are worked out to evaluate the performance of the business in utilizing the resources.

8. Helpful for forecasting purposes: Accounting ratios indicate the trend of the business. The trend is useful for estimating the future. With the help of the previous year's ratios, estimates for future can be made. In this way these ratios provide the basis for preparing budgets and also determine future line of action.

In spite of many advantages, Universal Teachers Publications (2010) establishes that there are certain limitations of the ratio analysis techniques and they should be kept in mind while using them in interpreting financial statement. Thus, Universal Teachers Publications (2010) outlines and explains the main limitations of accounting ratios as follows:

Net Sales = Total Sales -- Sales Returns

Therefore, Operating Profit Ratio indicates the earning capacity of the concern on the basis of its business operations and not from earnings from the order sources; hence it shows whether the businesses is able to stand in the market or not.

(d.) Operating Ratio

Operating Ratio matches the operating cost to the net sales of the business. Operating Cost means cost of goods sold plus Operating Expenses.

Operating Cost = Operating Cost / Net Sales*100 whereby

Operating Cost = Cost of Goods Sold + Operating Expenses

Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses -- Closing

Stock

Operating Expenses = Selling and Distribution Expenses, Office and Administration

Expenses, Repair and Maintenance

Operating Ratio is calculated in order to calculate the operating efficiency of the concern. As this ratio indicates about the percentage of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage. The less percent of operating cost to the net sales, so it is better for a concern to have this ratio in less percentage; therefore, less percentage of cost means higher margins to earn profit.

(e.) Return on Investment or Return on Capital Employed

This ration shows the relationship between the profits earned before interest and tax and the capital employed to earn such profit.

Return on Capital Employed = Net Profit before Interest, Tax, and Dividend / Capital Employed*100 whereby Capital Employed (Equity + Preference) + Reserves and Surplus + Long-term Loans -- Fictitious Assets

Or

Capital Employed = Fixed Assets -- Current Liabilities

Returns on capital employed measures the profit, which a firm earns on investing a unit capital. The profit being net result of all operations, the return on capital expresses all efficiencies and inefficiencies of a business. This ratio has a great importance to the shareholders and investors and also management. To shareholders it indicates how much their capital is earning and to the management as to how efficiently it has been working. This ratio influences the market price of the shares. The higher the ratio, the better it is.

(f.)

Return of Equity

Return on Equity is also known as shareholder's investment; and the ratio establishes relationship between profits available to equity shareholders with equity shareholder's funds.

Return on Equity = Net Profit after Interest, Tax and Preference Dividend/Equity Shareholders' Funds * 100 whereby;

Equity Shareholder's Funds = Equity Share Capital + Reserve and Surplus -- Fictitious Assets

Therefore, Return on Equity judges the profitability from the point-of-view of equity shareholders. This ratio has great interest to equity shareholders. The return on equity measures the profitability of Equity funds invested in the firm. The investors favor the company with higher ROE.

(g.) Earning Per Share

Earnings per share are calculated by dividing the net profit (after interest, tax and preference dividend) by the number of equity shares. Therefore,

Earnings per share = Net Profit after Interest, Tax and Preference Dividend/No. Of Equity Shares.

Otherwise, Earnings per share help in determining the market price of the Equity share of the company. I t also helps to know whether the company is able to use it equity share capital effectively which compare to other companies. It also tells about the capacity of the company to pay dividends to its equity shareholders.

CAMEL

According to Credit and Finance Risk Analysis (2010), the CAMELS approach was developed by bank regulators in the United States as a means of measurement of the financial condition of a financial institution. (Uniform Financial Institutions Rating System established by the Federal Financial Institutions Examination Council). Hence, Credit and Finance Risk Analysis (2010) declares that the acronym CAMELS stands for Capital Adequacy; Asset Quality; Management; Earnings (Profitability); Liquidity and Funding Sensitivity to Market Risk (losses arising from changes in market prices). Further, the Credit and Finance Risk Analysis claims that CAMELS analysis requires financial statements (the last three years and interim statements for the most recent 12-month period); cash flow projections; portfolio aging schedules; funding sources; information about the board of directors; operations/staffing; and macroeconomic information.

Recommendations and Conclusion

Personally, I recommend that both investors, financial institutions and department should analyze their financial statements in four stages i.e. (1) preliminary data adjustments; (2) ratio analysis; (3) assessment of accounting quality; and (4) valuation as recommend by De Mello-e-Souza and Awasthi (2009). This is basically done to establish gaps between fair values and market prices because such differences can cause significant losses to investors and may lead to legal action against the company and its executives, thus injuring the company's public image through financial unsoundness implication. Therefore, in-as-much-as ratio analysis has its own weakness; I still recommend firms to use it as a tool in performance measurement because the weakness can be minimized if the four stages of financial statements are followed appropriately.

Reference:

De Mello-e-Souza, C.A. & Awasthi, V.N. (2009).Probing Financial Statements in PostSarbanes-Oxley world. Strategic Finance. Retrieved on 3rd April, 2010 from http://findarticles.com/p/articles/mi_hb6421/is_10_90/ai_n31947078/

Credit and Finance Risk Analysis (2010). Bank Financial Statement Analysis & Ratio Analysis. Retrieved on 3rd April, 2010 from http://www.credfinrisk.com/bank.html

Sooper Tutorials. (2009). Financial Ratio Analysis and Formulas. Retrieved on 3rd

April from http://www.soopertutorials.com/business/finance/1992-financial-ratio-analysis-formulas.html

University of Windsor. (2010).Financial Ratio and Statement Analysis:

Sources of National American Industry Information. Leddy Library Resources.Industry Information. Leddy Library Resources. Retrieved on 3rd April, 2010 from http://web4.uwindsor.ca/units/leddy/leddy.nsf/BusinessFinancialRatioAndStat

ementAnalysis!OpenForm

Universal Teachers Publications. (2010). Ratio Analysis. Retrieved on 3rd April, 2010 from http://www.universalteacher4u.com/cbse/xii/acctheory/ch11/page1.htm