Thesis on "Financial Ratios"

Thesis 7 pages (2290 words) Sources: 10

[EXCERPT] . . . .

Ratio analysis has become one of the most prominent forms of financial analysis in business. The technique, which was originally developed to analyze credit in the short run (Horrigan, 1965) has risen to prominence because it offers a variety of advantages. However, its popularity belies the fact that ratio analysis also has many limitations. For the first several decades of ratio analysis, such limitations were given little consideration, since it was widely felt that ratio analysis was beneficial (O'Connor, 1973). Any individual using ratio analysis to understand a company's operations should understand these limitations. Ratio analysis is but one tool that can be used to analyze a company and is not intended to be the only tool. This paper will discuss the benefits and limitations of ratio analysis, including the factors that may affect the usefulness of the information contained in financial statements.

Benefits

Ratio analysis has risen to prominence because it offers a large number of benefits to end users. Analyzing a company's operations is a difficult endeavor, especially for those outside the industry. What the numbers contained in the financial statements do is give the outside observer hints as to the company's recent performance and the trends in that performance. Financial statements can be confusing but ratio analysis provides a framework by which the user can begin the process of breaking down those statements into useful information. Not only does ratio analysis provide this framework, but it is easy-to-use. As the world moves towards more consistency in accounting standards, ratio analysis allows for comparisons to be made between companies and industries as well.

The ease of use of ratio analysis is one of its most important features and is an undoubtedly a major contributor to its rise in popularity. Anybody with an Internet connection can get the basics of ratio analysis, the formulas for key ratios and instructions on how to interpret these figures. Some websites, such as Reuters or MSN Moneycentral, publish certain key ratios for publicly-traded firms. With the basics formulas in hand, virtually anybody can tabulate ratios, perform a trend analysis and being to get a basic feel for a company's financial position.

The framework provided by ratio analysis is another of its main benefits. It provides a valuable starting point for understanding a firm's financial position. By using the same ratios for a wide range of different companies an individual can quickly become adept at using this framework and very quickly break down a company's statements into usable bits of information. After this basic framework has been utilized, a more comprehensive analysis can begin, but ratio analysis is a valuable starting point whereby key issues can be identified and subsequent investigation focused on these particular trends or anomalies.

Another benefit of ratio analysis is that it allows for comparison between different firms. This is achieved because ratio analysis normalizes the data, allowing for companies of different sizes and forms to be more easily compared (Paulson & Huber, 2000). The objective of standardization of accounting principles and reporting methods is intended to allow for greater transparency and comparability. This helps investors to determine where to put their money and assists financial institutions in making lending decisions. Ratio analysis flows from this in that it provides a common framework by which these statements can be analyzed. The same measures are used across almost every industry. The common framework for analysis therefore improves the relevance of financial information to investors, regulators and bankers.

Limitations

These advantages have contributed to the ubiquity of ratio analysis. Yet, in many ways, they belie the limitations of the technique. There are several. Ratio analysis can be vague, especially for conglomerates; is does not explicitly tell the whole story of a firm's finances; it does not address different accounting practices between firms; is uses historical data; ratios can be interpreted differently by different users; and data may be incomplete or subject to window dressing or timing manipulation (NetTOM, 2009).

It is important to remember that financial statements are themselves aggregates of a vast amount of accounting information. Ratio analysis is essentially distilling this information further. The further the data is taken from its original form, the less insight it provides. This is especially true in the case of conglomerates, where multiple business lines and geographical regions contribute to the financial statements. Ratio analysis is severely limited in its ability to yield understanding of the complexities of individual components of a large corporation's business. The key drivers are almost entirely ignored in the process.

Further to this, ratio analysis does not tell the entire story of a firm's operations. When financial statements are presented, they are accompanied by pages of notes, in which key details are revealed. Ratio analysis, however, does not incorporate these notes. Without an understanding of the information contained in the notes, the ratios are less valuable, since they represent an incomplete version of the firm's information.

Despite the move towards increased accounting consistency in recent years, there are still many circumstances in which firms can differ with respect to accounting policy. This reduces the usefulness of ratio analysis in cross-company comparison. Because ratio analysis is the best method by which we can make these comparisons, the temptation exists to think that these comparisons are perfect yet in many cases they are not, meaning that the ratios are being used improperly.

Also of concern is the fact that ratios reflect historical data. Ratio analysis is used to gain an understanding of a firm's financial position, yet the data used does not reflect the current circumstances. There is little the end user can do to accommodate this limitation other than to understand that it exists.

Another limitation is that ratios are interpreted differently by different users, and across different industries. While the technique is a valuable tool to help with cross-company comparisons, each firm and each industry has its own norms with respect to these ratios. Airlines, for example, tend to have far higher debt ratios than most companies, such that a healthy debt ratio in that industry would be considered unhealthy in most others. The structure of each industry must be taken into account when conducting a ratio analysis. Moreover, within industries firms competing may not be equal. Different firms compete on different bases and may be subject to different risks. These will be reflected in the financial statements. Blind interpretation of the statements without considering these differences will yield inferior interpretation. Moreover, even with consistency in reporting standards and ratios, there is no guarantee of consistency with respect to the interpretation of ratios by different end users. The same numbers can mean completely different things to different people, depending on their knowledge, experience and biases.

Factors Affecting Ratio Analysis

There are many factors affecting the validity of ratio analysis. One factor is the guidelines for reporting. Statements from the Financial Accounting Standards Board are applied in concert with the Generally Accepted Accounting Principles to create the statements, with consistency as one objective. However, there are many areas where the company retains the option between different standards. Likewise, the standards themselves are subject to change, as the FASB issues different statements. There is also a competing set of standards used internationally, issued by the IASB. There are efforts to merge these standards with those of the FASB such that standards are applied globally but as of yet the two different bodies are independent, making ratio comparison between U.S. And non-U.S. companies more difficult.

The legal environment is another consideration with respect to ratio analysis. New laws such as the Sarbanes-Oxley Act can impact the way that financial statements are presented. This affects the ratios that come from the statements as well. Users of financial statements must understand the impact of these regulatory changes when conducing ratio analysis.

The experience of the user will also be a factor. Ratio analysis is a valuable tool when used properly. This typically means that the user has some experience in using this technique. Each firm and each industry are different, and the user must have the ability to analyze the ratios within the context of these differences. The objective of consistency does not imply that statements can be directly compared with one another. An experienced user should be better able to interpret financial ratios. Likewise, a user with in-depth knowledge of the industry or the company's operations will be better equipped to understand the meaning of the ratios. A spike in debt, for example, could signal trouble, or it could signal the acquisition of a rival. It is important that the financial ratios are not taken out of context of the firm's operations.

Emerging Thought

The basics of ratio analysis have changed little in recent years, and the academic study has tended to revolve around the same handful of subjects (Salmi & Martikainen, 1994). The technique has remained largely the same, as have the limitations. However, there is work being done to reduce the impact of those limitations. First, most professionals understand that ratios… READ MORE

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