Financial ratios are used to measure a company's financial strengths and weaknesses, as well as the profitability of a business. Investors can use financial ratios to evaluate the performance of a company by comparing them to others in the same industry.
For instance, the dividend payout ratio can be used to figure out what percentage of the companyís earnings is being paid out to shareholders in the form of dividends. Generally, the higher the payout ratio the more attractively are shares of the firm seen by stock traders. This also indicates that the company pays more in dividends and thus less earnings are invested back into the business to create future growth.
Following are the main advantages of Financial Ratio Analysis:
1. Ratios are easy to understand by all users.
2. It is a very useful technique for comparison purpose. Changes in ratios over time can indicate the firm's performance, and it can also be used to compare with businesses in similar industries.
3. The calculation of profitability ratios can help to measure the profitability and actual performance of the businesses.
4. The use of various liquidity ratios can indicate the short-term financial position of the company.
5. Remedial actions can be taken if weaknesses are found through ratio analysis.
6. Important ratios help the external parties such as shareholders, debenture holders, bankers to know the performance of the company that pay them interest and dividend.
7. The use of ratios simplify accounting information as they summarize the result of detailed and complicated computations.
8. Accounting ratios can indicate the trend of the business line and is useful for forecasting purposes.
9. It helps the company in analyzing the utilization of its various assets and liabilities.
Following are some of the limitations of Financial Ratio Analysis:
1. Ratio analysis indicates only the areas of strengths and weaknesses, without investigating the causes.
2. Different companies can apply different accounting policies. Thus the ratio of one company can not always be compared with that of another company.
3. Ratios are calculated based on outdated information presented in the financial statements. The use of historical costs may not be appropriate for decision making.
4. It may lead to distortion caused by inflation. Price level changes can make the comparison of figures difficult over a period of time.
5. Ratio analysis is mainly a technique of quantitative analysis and it ignores some important qualitative factors which can be critical in decision making.
6. Effect of window dressing by preparers of financial statements.
7. Ratio analysis is costly and small businesses may not be able to afford it.
8. There are no standard ratios. One specific ratio can have different formulas which may lead to different outcomes and difficult for comparison purposes.
9. Ratios are relative figures and do not indicate the size of a firm.
10. Lack of benchmark.
11. Accounting standards and practices in different countries vary widely, and this may hamper meaningful global-performance comparisons.
Following Analysis we are going to see in the following post.
1. Investment Ratio Analysis & Example
This is used by shareholders or investors to calculate the return on their investments, and to make good decisions about which shares to buy...
2. Financial Leverage Ratio Analysis & Example
This is used to assess the financial position of a company in terms of its financial stability. It gives an indication of the firm's ability in repaying its long-term debts...
3. Profitability Ratio Analysis & Example
This is used to assess the profitability of a business in relation to its past performance, or in relation to other companies in the same industry...
4. Efficiency Ratio Analysis & Example
This is used to analyze how efficiently the firm uses and controls its assets and liabilities internally...
5. Liquidity Ratio Analysis & Example
This is used to measure the ability of the firm in meeting its short-term liabilities...