Benefits and limitations of financial ratio analysis in practice

Ratio and Financial Statement Analysis

The topic for this essay is ratio and financial statement analysis. It is meant to show and analytically examine the benefits and confines of ratio analysis by elucidating what factors impact the significance of such methods and what new theories or practices may be developing regarding the presentation and application of ratio and financial statement analysis. Emphasis on practical applications will come from peer-reviewed articles.

The articles are within the last five years as well as use real-world ratios synthesizing. They are a mixture of researched material and studies. From the start of January 1, 2011, the majority of the world fiscal market economies utilize International Reporting

Standards or IFRS as the obligatory outline for financial statements. This has a large part to play in the significance of ration and financial statement analysis.

Studies like one done in Romania through use of logistic regression attempts to see if this methodology can be employed as a model to precisely forecast the business bankruptcy likelihood over the fiscal crisis period. Through financial statement analysis, by utilizing synthetic financial statements, they constructed twelve ratios and from these twelve, five proved major within forecast of corporate bankruptcy in a logistic model. This is an example of real world application of ratios to solve real world problems.

Another real world application of ratios and financial statement analysis examines how a retailer's accounts receivable quantities and the business' days' transactions in accounts receivable are influenced by the company's selection of whether to preserve the management of its credit-card process in-house or subcontract it to an economic institution. It highlights the rising trend toward subcontracting of credit-card processes. It also shows how it generates major difficulties for analysts as they try to make intra- and inter-firm assessments of retailers' using the DSAR metric. Here is an excellent example of the growing obstacles put in front of those utilizing ratios and financial statement analysis.

Introduction

Computation or analysis of financial ratios as well as when performing other financial statement analysis is a complex and ongoing process. Those that practice such methods must always keep in mind that accounting principles are reflected in the financial statements. This signifies assets are typically not reported within their present value. It is also probable that numerous brand names as well as unique merchandise lines will not be incorporated amid the assets described on the balance sheet. This, even while they may be the greatest valuable of all the articles owned by a business.

These instances are indications that financial ratios plus financial statement analysis present with limitations. In addition, it is also imperative to understand that a remarkable financial ratio within one industry a business or industry might viewed as less than extraordinary in a dissimilar industry. One organizes financial ratios plus financial statement analysis as follows:

Balance Sheet

Overall discussion

Common-size balance sheet

Financial ratios centered on the balance sheet

Income Statement

Common-size income statement

Financial ratios centered on the income statement

Literature Review

This literature review is meant to display ratio and financial statement analysis in real world settings and real world applications. Some are studies that show the use of ratio and financial statement analysis in real world situations. It also describes the other facets that goes into the analysis. Things like IFRS and other accountant terms will be discussed through these articles to help provide better context surrounding the topic. Some articles also provide results that support the use of ratio and financial statement analysis in prediction and estimation.

In an article explaining the use of ratios over IFRS rules, the ratios evidently specify that IFRS guidelines result in more traditional ratio results with regard to the present and long-term creditor when likened to U.S. GAAP. The article also explains every liquidity ratios is lesser under IFRS also the variances are noteworthy. Likewise, all long-term ratios lend towards more conservative when likened to U.S. GAAP. The insinuations here is that the rules of IFRS will have far grander undesirable implications on things like bond covenant agreements including other short- and long-term creditor lawfully binding agreements than U.S. GAAP.

IFRS represents the future of international financial reporting and must be involved as a foremost part of any accounting and/or corporate prospectus in the United States, including the rest of the world. "This case illustrates a situation where a Balance Sheet and Income Statement is prepared using GAAP as a basis and converting to IFRS for comparison purposes, with the focus being from the creditor point-of-view" (Harris, Stahlin, Arnold & Kinkela, 2013, p. 49). So essentially, the case study examined and discussed the rules of as well as key Lease accounting comparisons and differences amongst GAAP and IFRS. In addition, they addressed its consequences on the company's creditors. This article shows just how important certain aspects of accounting are when dealing with ratios and analysis.

In another article by Daniel & Ionut, the costumer receivables gathering period shows a progressive connection to the bankruptcy prospect in the projected model, which proposes that higher bankruptcy prospects are connected to the businesses with high costumer receivables gathering periods. "The fixed assets ratio, the fixed assets turnover ratio, the equity working capital and the autonomy ratio showed negative correlations to the estimated probability of bankruptcy, which suggests that high values of these ratios are associated with low bankruptcy probabilities" (Daniel & Ionu? 2013, p. 983). Analyzing ratios in this article shows how one can predict bankruptcy probabilities.

For one to validate properly the model within a spatial out-of-sample base, the businesses from the target populace were selected randomly and split in two approximately equal groups:

estimation group (2165 companies) and validation group (2162 companies)."The model generated through logistic regression offers an in-sample overall 70.3% accuracy in the prediction of the bankruptcy event, with an out of sample overall accuracy of 67.6%. The accuracy rate on validation sample rises slightly to 67.9% if Ewc2 is added" (Daniel & Ionu? 2013, p. 983). These calculations show real world use of ratios in terms of predicting outcomes and behaviors within a business setting. Ratio analysis, financial statement analysis, enables a better understanding of the current condition within the business and helps see the future. The future always has innumerable possible outcomes. Ration analysis in this instance, narrows the gap.

Gosman & Ammons write an article discussing real world interactions of people within their workplace and their guesses on DSAR. Jill was one employee mentioned. She had predicted, she and her other coworker Bob, were astonished by the very small DSAR for their store Macy's and the substantial (57-day) variance amid the two department stores. "Bob suggested that they re-cheek the EDGAR data for Macy's and then recalculate the ratio. Unfortunately, this step did not resolve their dilemma as they determined that the data initially used and the DSAR calculation that they had made were accurate" (Gosman & Ammons 2013, p. 3). When they recalculated the ratio, they saw the differences and were able to gain a more accurate assessment.

Ratio and financial statement analysis enables higher rates of accuracy. Accuracy remains an important element in any business. A business like Macy's relies on accuracy as inventory and sales are numerous. It is a big chain department store with many employees. Things must be kept in track of, especially financials. That is why ratio analysis becomes an indispensable tool.

A study examined the economic status of unstable university hospitals. They did so through evaluating if they did or did not meet financial standard ratios. Their general results demonstrated that the financial standing of several of the university hospitals were and remained unstable. This was seen through examination of the many financial indicators that these hospitals failed to meet in terms of financial standard ratios. Only eight financial indicators of the sum of nineteen indicators fulfilled financial standard ratios.

The results of financial statements analysis suggest that nurse managers should develop the blue ocean strategy for diversification of nursing services to improve financial ratios of liquidity, performance, and growth. Using a unit-based just-in-time system for effective supply management would help to increase profits and to decrease costs of hospital by improving financial ratios of turnover (Lim, Noh, Oh & Kim, 2013, p. 7).

Another article explains the quality of a business shows signs of a successful and safe business. Businesses utilize dissimilar financial ratios to assess the financial performance and condition. However, there is not a certain list of financial ratios businesses use; it is significant to interconnect two values of the same type. For example, the given standards would only than be expressive. "Financial ratio analysis provides answers to several questions: is the entity primarily financed by foreign sources of assets, do the customers pay promptly and in accordance with the contracted agreement, are the operating costs too high and do they endanger the long-term stability and business performance" (Harris, Stahlin, Arnold & Kinkela, 2013, p. 377).

The implication of certain financial ratio fluctuates contingent on the data needs of the users. "Creditors are interested in the information regarding due payment of their loans and the interest. Liquidity and solvency of their clients are of their primary concern. Equity investors (shareholders) are concerned with long-term profitability and financial condition" (Harris, Stahlin, Arnold & Kinkela, 2013, p. 377). Starting with the organization's point-of-view, overall use of financial ratios within a business setting serves as the comparative magnitude of two or more designated arithmetical values derived from financial statements, which can elicit a better decision-making process for a business. The considered alignment of an entity, its environment and the supervisory framework, opposition and the branch of commerce are of momentous importance in comprehension and proper interpretation of the financial ratios.

Real world scenarios are key in understanding the use and benefit of financial statement and ratio analysis. In an article where the authors examined if and ultimately how expressively the recording of accounting communications in accordance with the Czech accounting legislation did concerning ratios; they wanted to see if the IAS/IFRS was able to alter the results of four chosen financial ratios. These ratios describe main features of fiscal management of the business. The involvement of the authors consisted of generating an at the time, unpublished model confirming the existing differences between IAS/IFRS and the Czech accounting legislation. "These differences influence the amounts of items that are disclosed in financial statements especially in the balance sheet and income statement. Dissimilarities in input data have caused different results of the four selected financial ratios" (Malikova & Brabec, 2012, p. 162).

When looking at the rest of the article, the highest difference the authors detected was through return on capital-employed ratio as well as through debt ratio. Whereas the outcomes of asset turnover ratio plus acid test ratio were not shown to illicit significant differences. This may be caused chiefly through selection of the defined accounting transactions. These transactions may have predetermined especially the quantity of operating profit also the arrangement of liabilities and equities, while the variances in preliminary measurement of resources did not show significance. "In the case of asset turnover and acid test ratio the own construction of the ratio diminish the differences because separation of interest influence both parts of the fraction" (Malikova & Brabec, 2012, p. 162).

Ultimately, ratios represent a much larger aspect of a business then people expect. Analysis of such ratios determines many outcomes. It also enables information retrieval and higher accuracy.

The purpose of a 2012 study was to deliver financial ratios' maximum and minimum values that businesses used in the 2006-2010 decision-making process. The study continues by explaining ratio analysis in terms of only one output and input. Furthermore, the author's states ratios can be paralleled separately. When the study assessed several businesses' financial performance, one of the approaches they utilized for comparing was Decision Making Units or DMUs, Data Envelopment Analysis or DEA. Ratio analysis and DEA when used in conjunction, support each other considerably.

Accepting some of the ratios as both inputs and outputs, the authors determined financial interim efficiency assessments. "Y-lmaz ve C-rac? (2004), Kavakl-dere ve Karg-n (2004), Y-ld-z (2005), are examples to studies of performance in cement sector in Turkey. In all of these studies, classical DEA models are used. Analyses are made by average values or for years separately (Ba-kaya & Ozturk 2012, p. 177). This shows other routes of analysis when considering ratio analysis. The authors determined the use of DEA could support the process of ration analysis in a beneficial and more effective manner.

Another article compares the CK paper and demonstrates their models of financial statements are founded on Benninga's deterministic sales driven model. The model projects upcoming sales supposing the continuous growth rate. As the authors explained, the CK study assessed the sales growth degrees using a univariate time trend model. They explain the model through Home Depot Sales.

Our sales model assumes that the continuously compounded annual SALES growth rate (equal to the first difference of the natural logarithm of SALES) depends on a time trend and the consumer sentiment index.

Therefore, the sales model directly or indirectly takes into consideration the three interconnected macroeconomic influences on the Home Depot transactions forecasts.

Conclusion

In conclusion, financial statement and ratio analysis have many facets to examine and discuss. In both theory and real world application, it can be simple and complex. Performing such functions allows for higher accuracy within business financial statements. It also allots companies methodology that is both effective and less time consuming. It promotes a stable and successful business.

Businesses often overlook a lot of the resources used and the processes happening within the financial infrastructure of the company. Close examination of the financial statement and ratios helps eliminate unintended neglect or oversight. It can also be good at forecasting potential bankruptcies. Business do not under any circumstances want to owe more than they make. Keeping continuous evaluations of financial statements helps that. However, one has to understand what ratios are used and what they signify.