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Report on Ratio and Financial Statement Analysis - Critically analyze the benefits and limitations of ratio analysis

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Ratio and Financial Statement Analysis

Executive Summary

 

Preparation of financial reports pertaining to the operations of the business entities are done with an intention of disseminating important information in an objective manner to the stakeholders. The financial reports contrails details of the financial strength and weaknesses of an entity in the fiscal year gone by and allows the stakeholders to use the information contained therein a logical manner to find the effectiveness with which assets are utilized and returns generated. For this to happen though it is necessary that ratio analysis is used in a sequential flow and the computed ratio are then compared. The computed ratios would often be used to find out the logical efficiency and improvements made in the usage of assets to generate returns and the weaknesses in the financial numbers. Thus, it becomes extremely helpful for the stakeholders the effectively evaluate the businesses strengths and make necessary decisions based on the comparison and computation. 

 

Ratio analysis is one of the primary tools for evaluating the performance but the same would be more and more useful only when the ratios are computed for a number of years in a sequential and continuous basis. An identical firm in the same segment of the industry be chosen to make efficient comparisons and ratios be presented in a manner that can be termed standard. However it shall be remembered at the same time that ratios would be as effective as the no’s present in the financial statements published by the entity. If the numbers contained in the financial statements are fraud numbers, then the results would not make any sense. 

In this report there would be an emphasis on making sure the benefits and weaknesses of ratio analysis as a financial statement analysis tool is evaluated with proper care. 

Introduction 

 

Ratio analysis happens to be the tool which is often used as a primary measure to compare the financial results of companies and business entities using the results published in the form of annual reports etc. these ratios link all the major financial statements found in the annual reports and other quarterly reports etc. and helps to find the efficiency with the business is conducted and how the assets and other resources are used to generate profits for the stakeholders. Because of its ability to make suitable comparison, ratios are the most used fundamental analysis tool in business segment across the world (Adedeji, 2014). 

However, the use of financial ratios would often vary across sectors and segments of different individual industries because of a variation in size and stability of the business and this is why the computed ratios must be compared against companies of similar size and in the same industry. 

 

Analysis of benefits of Ratio and Financial Statement Analysis 

 

Benefits of Ratio analysis can be manifold for different stakeholders:

When business entities undertake decision the same can either be proved and validated or disproved through financial analysis and computation of different ratios. Financial statements of entities can be summarized in terms of a variety of comparative ratios and thus the stakeholders would have the opportunity of validating their aspirations and the management can take decisions to improve the results (Barnes, 2007). 

Complete account statements are pretty imposing for general investors to read and make logical conclusions. This is where the ratios and the trend analysis can come in handy to find the rate of growth of revenue, the percentage of GP and NP and find the growth of expenses in comparison to growth of revenues. It would also be interested to find which expense category is expanding greater than revenue growth and impacting profitability negatively and vice versa (Nuhu, 2014). 

Ratio Analysis can eb sued to identify those areas in which an entity is doing well and those areas in which the entity is not so well off. Management of the entity can work upon these areas to increase efficiency. From example the Gross margin of a company is better than competing firm, but its net profit is much lower. The same is because of increased operating expenses and hence management can take steps to reduce expense in future by identifying the higher cost origins. Ratio and trend analysis can be used to pinpoint problem areas which needs greater emphasis (Elliott & Elliott, 2017). 

A Ratio analysis done well can be used for making suitable inter firm comparison and also be sued to make the ratios of one entity compared to the industry ratios. This is done to make sure the management and the stakeholders better understand where they stand in terms of performance in relation to the whole industry. More improved decisions making can be made possible with effective comparison (Kimmel, Weygandt, & Kieso, 2011). 

A financial report presented by an entity is supposed to be objectively prepared to disseminate correct information to the shareholders. In this aspect the shareholders can learn about growing trends by preparing a horizontal trend analyst. Under this statement both the absolute dollar amounts and the % of the total is displayed. This statement can pin point which items are exceeding the previous years values and by how much the same is disproportional to the sales growth etc. Watching these trends over a few years provides a definitive indication towards the real growth of the business and appropriate decisions can be made to eliminate the negative effects (Babalola & Abiola, 2013). 

Similarly a vertical trend analysis can also be undertaken for assets , liabilities and equities etc. presented in the balance sheet showing each item as a % of the total assets etc. This allows the management and others analyzing the balance sheet to know which items are growing ( if required) and which are shrinking thus making an impact on the balance sheet and performance of the firm and thus effective measures can eb initiated to reduce the negative impact (Gallo, 2015). 

Analysis of the limitations of Ratio and Financial Statement Analysis 

 

Financial statement analysis including that of ratio computations is one of the finest tools for measuring efficiency with which organizations are run and managed and is quite good in measuring past activities, but it suffers from several limitations simply because it does not and it can’t predict performance into the future. Thus, it can be called one-dimensional. Issues which often arise in the financial statement analysis are as follows:

Problem of Comparability between different Companies 

Finding a suitable company for making effective comparisons of the ratios and trend analysis etc. becomes tedious if a company with similar features operating in the same economic environment is not selected. If a wrong company is selected for making a significant no of comparisons, then the conclusions reached would significantly working and unidimensional. For example, making a cross country comparison might be quite difficult as companies operating under different economic environment would be quite different form each other (Saxena, 2016). 

Problem of Comparability between different Periods /different methods 

 

Under financial statement analysis and ratios to be comparable the entities must be suing same type of accounting methods and same period of expense and other item reporting. For example, the sales revenue is reported in year 1 and resultant sales expenses are recorded in the year 2, then the same can’t be compared to other companies using uniform year format. Different accounting methods also make for unusual and unsuitable comparisons (Wang, 2014). 

Ratios and other tools does not account for inflation etc. 

As inflation is constantly changing from one year to the other the results are not comparable unless suitable adjustments are made to the numbers presented in the financial reports. For example in year 1, the rate. of infmaiton is 5% and in year 2 , the rate of inflation is 9%. Thus the growth of sales revenue and profits are required to be adjusted for inflation which is not done and which skews the suitability of comparisons. 

 

Conclusion 

Financial statement analysis and Ratios are used to stitch together he information provided by three different financial statements in the annual reports and thus generate ratios and figures which becomes easily comparable across nations and across industry as well. Investors often use the ratios computed to have a general feeling of the dimension of growth and the attractiveness of the industry for making decisions for new investments. However, the Ratio and other techniques of financial statement analysis is only limited to finding answers to past results as the information pertains to the historical costs. Thus, it can’t be used to predict the future and is only useful for providing clues to improve the past results in the future period. Nevertheless, the analysis helps the managers, business owners, shareholders and analysts to find chinks in the way businesses are operated and improve the performance in the coming years through suitable adjustments made to the capital structure, long term contracting and alteration of purchases etc. aiming to reduce costs and increase earnings. 

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