Management Practices: Ratio Analysis
Management practices depend on the ratio analysis to evaluate the financial performance of the company as well as the investors to make informed decisions. They can access the profitability, efficiency or liquidity of the organization. They, therefore, help in the comparison with other firms in the same industry for proper analysis. However, ratios analyses are affected by the past information since the investor of any company requires examination of the current data.
Ratio analysis helps the organization in various ways since it is involved in stock valuation and forecasting of the enterprise's future financial performance. Investors depend on the information gathered from the analysis to make informed and accurate investment decision. However, ratio analysis is affected by various factors such as accounting standards and internal controls. Moreover, technology has considerably improved and has a significant impact on the reliability of the ratio analysis. The objective of the paper is to help users and other stakeholders understand how this type of analysis is used to evaluate the performance of business.
Ratio analysis is used to analyze financial statements in any fiscal year by comparing the ratios with the previous years. The latter are classified into various types such as debt management, profitability and liquidity ratios among others. Ratio analysis mainly focuses on the items in the financial statement. They are, therefore, applied to evaluate various elements of the company's economic performance such as profitability. Furthermore, the ratios are studied to assess if they are improving for the better as well as they are compared with different companies in the same industry for proper analysis. Ratio analysis is the most common tool used for appropriate examination of the organizations performance. In addition, it is easy to apply, use and require mathematical computation. Overall, ratio analyses contain various benefits and challenges in the application and are affected by different factors.
Ratios perform a major role in the analysis of the financial statements of any given company (Ak, Dechow, Sun & Wang, 2013). It is a very important tool for most of the people who depend on the financial statements such as investors, creditors and managers among others. There are two main methods for evaluating the financial statements of any firm which include horizontal and vertical analysis. The horizontal analysis uses the comparison of the company's financial data gathered over a period (Brigham & Ehrhardt, 2013). In contrast, vertical analysis represents the comparative evaluation of various financial statements where every item is the percentage of a given item in these statements. Therefore, the accountant of any firm must perform proper analysis that will help in the development of the entity. The employees and the management of most organizations should apply ratio analysis to examine the financial performance because they enable managers to predict the future events set to happen in the market.
Benefits of Ratio Analysis
Ratio analysis is a tool applied to evaluate the strength of the firms performance by calculating various items on the financial statements. Many users of the financial statement depend on the ratio analysis results to make investment decisions (Brigham & Ehrhardt, 2013). The benefits are the following.
Ratio analysis offers the best method to compare various companies' performances. Ratios help in the comparison of businesses as they assist in indicating the best profitable firm and the one making frequent losses. They, therefore, involve numbers to reveal the profitability of the organization and the level of sales recorded. Using various ratios such as return on investment or net profit margin, they can ensure the proper contrast. A firm that performs well in the market when compared to another lower-level company may help the organization learn a lot and increase its sales. Eventually, the comparison is made using two different financial years (Bragg, 2012).
Ratio analysis can help reveal the trends in industry areas, hence, creating a platform where the performance of all the players in the sector can be measured. Small and growing firms can depend on the ratio analysis to create their organizational strategy where they can be able to measure their performance in the industry. It will, therefore, help to shape the growth of other industries and increase market share. The different industries are affected by factors either internal or external and ration analysis can help to overcome those aspects (Healy & Palepu, 2012).
Ratio analysis helps the investors and the other financial analysts to evaluate and understand the strengths and weaknesses of various individual companies. Thus, the ratios will contribute to determining the strengths of the firm for the investors dependable on them. They can, therefore, help to reveal which companies are the best to invest in due to their increased stock valuation. Obviously, the investors want to contribute money in firms with strong stock valuation and increased profitability in the market.
Planning and Performance
Ratio analysis can offer guidance to many entrepreneurs who hope to start their own business with the primary aim of profit generation. They will be able to use the industry trends as the baseline where they can set goals and objectives to accomplish over a given period. Ratios also serve in the creation of the strategic change in the organization for future growth and success. The ratios are, therefore, make the managers responsible to be on their toes where they can be able to identify any weakness and opportunities. They are best suited for the growing and upcoming business for future prosperity (Kumbirai & Webb, 2013).
Analyzing Financial Statements
Ratio analysis has a significant role in financial statements analysis as it helps in the proper understanding of the financial performance of the firm. Different users of the financial statement such as bankers, investors, managers and government depend on it in order to analyze the financial statements critically. The analysis may indicate increased profitability, liquidity problems or distress issues. Various decisions result from the analysis of the financial statements where corrective measures are introduced to tackle any problem observed.
Many firms depend on the ratio analysis to predict the current and future trends in the production. It, therefore, offers an opportunity for financial forecasting of the origin of the budget for the planning process. As a result, it will help in the performance analysis over a given period.
Ratio analysis helps in the computation of the stability ratio which allows dominance of the solvency issues. The assets should always be more than liabilities to ensure healthy operations of the company.
Limitation of Ratio Analysis
Although ratio analysis plays a major role in financial statements analysis, it also has a few limitations listed below.
Firstly, the analysis does not take into account the inflationary effects in the marketplace. Since financial records are conducted over a span of years, they may not give correct and accurate information for the reason that the effects of inflation also require consideration (Damodaran, 2012). For example, an asset purchased over five years ago is recorded at the historical rates in the financial statements. Therefore, the records may not have the same value currently due to the inflation factor.
Not Suitable Comparing Firms in Different Industries
Financial experts cannot use ratio analysis while comparing companies in the different industries. It is because the various industries have their unique capital structures and market shares. Consequently, it is suitable only for firms in the same industries to achieve proper analysis (Uechi et al., 2015).
Accounting Practices Challenges
Different firms use various accounting practices since they may use different inventory valuation methods or depreciation valuation. Therefore, comparing ratios of such companies will lead to inaccurate data and information.
Quantitative Measure, not a Qualitative Measure
Ratios analysis applies mathematical measures in its examination. It is, therefore, a quantitative measure which deals with the proper analysis of the cyber business (Jegadeesh & Wu, 2013).
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Ratio analysis mainly analyzes past information while most of the users of financial statements require current data to be examined.
Factors Affecting Ratio Analysis
Estimates and Assumptions
Financial information is mainly affected by any estimates and assumptions made in the financial statements. Therefore, ratio analyses are affected by the two factors since they can produce the accurate and correct analysis.
Internal Control System
Internal control represents the various processes and actions carried out by the management and employees to offer assurance in the efficiency and reliability of the financial statements. Strong internal control systems ensure the organization follows all the set rules in the financial statements. Therefore, they affect the meaningfulness of ratio analysis in the examination of the firms books of accounts.
Accurate financial statements have the great impact on the effect of ratio analysis. Hence, they help in the attainment of the goal of the ratio analysis which is to evaluate the performance of the organization throughout certain time. Investors also depend on the ratio analysis to make their investment decisions.
Accounting standards are the guiding feature in the application of the ratio analysis. They are accepted and applied widely in the financial statements preparation. The use of accounting standards is the primary foundation on which users of financial statements can depend while the data is being prepared. Importantly, the standards help to strengthen the reliability of the ratio analysis.
Laws are applied by various bodies that govern the accounting profession and help to ensure firms can fully disclose enough information. Full disclose of the information allows the accounting staff to prepare comprehensive and accurate financial statements (Gatti, 2013). Therefore, ratio analysis will be correct and effective to its users.
Modern and advanced accounting software has been developed to help in the accounting field. They help in the fast and reliable analysis of the financial statements as well as preparation. Technology plays a great role in the ratio analysis since most of the figures and computations currently are done by the new software.
Practical Application of Ratio Analysis
Ratio analysis is applied in the financial department to analyze the performance of the organization. It is also currently used in the real world situations where two financial years are taken for the analysis and comparison. Additionally, the analysis is computed to evaluate the financial health of a company and applied to examine the profitability of a firm, among others through the use of the ratio formulas (Bentley, Omer & Sharp, 2013).
Ratio analysis involves mathematical comparison of the books of accounts of any firm. It helps various users of the financial statements to understand the business operations and the uncertainties. Moreover, the analysis is a common tool used in the business operations and mainly applies to firms within the same industry sector. The ratios are faced with various benefits and challenges in the application. They assist in the stock valuation and are also affected by past information. The investors require the analysis of the current data, hence, a major hindrance. Internal control system and the financial estimates and assumptions are the main factors affecting the application of ratio analysis.