Essay on "Ratio and Financial Statement Analysis"

Essay 10 pages (3142 words) Sources: 5

[EXCERPT] . . . .

Ratio and Financial Statement Analysis

The purpose of this essay is to critically analyze the benefits and limitations of 'Ratio and Financial Statements Analysis', explaining which factors impact on the meaningfulness of the financial ratio analysis; and establishing the new practices or theories that may be emerging regarding the application of ratio and financial statement analysis.

The essay covers 'Ratio and Financial Statements Analysis' with a critical analysis of the benefits and limitations of ratio analysis; it explains the factors that impact on the meaningfulness of such measures. In between, the essay outlines and explains the four stages of financial statements analysis. More so, the essay explains CAMEL as a new practice or theory that may be emerging regarding the application of 'Ratio and Financial Statements Analysis'. Consequently, it emphasizes the practical applications and real-world use of ratios. Besides, all references that have been used are less than 3 years old.

Finally, I have given personal recommendations pertaining 'Ratio and Financial Statements Analysis' just after a conclusion.

Definition Advantages and Limitations of Ratio and Financial Statement Analysis

According to the University of Windsor (2010), financial ratio and statement analysis is one way to analyze a company's financial performance. It looks at the relationship among elements contained in the financial statements. It is usually used to analyze a company's performance history, to compare a company to specific competitors, or to compare a company to its industry. Sooper Tutorials (2009) declares that financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements. The level and historical trends of these ratios can be used to make inferences about a company's financial condition, its operations and attractiveness as an investment.

Accordingly, Sooper Tutorials (2009) claims, financial ratios are calculated from one or more pieces of information from a company's financial statements. Sooper Tutorials gives an example of the "gross margin" whereby it declares that it is the gross profit from operations divided by the total sales or revenues of a company, expressed in percentage terms. Besides, Sooper Tutorials (2009) declares that in isolation, a financial ratio is a useless piece of information; and that in context, however, a financial ratio can give a financial analyst an excellent picture of a company's situation and the trends that are developing.

De Mello-e-Souza and Awasthi (2009) declares that financial statement analysis involves exploring a company's numbers in search of explanations for past performance as well as telltale signs about the future. Like a detective, the analyst is seeking the key to unravel a mystery or patterns to help organize a vast array of numbers. De Mello-e-Souza and Awasthi further claim that financial statements are typically analyzed in four stages: (1) preliminary data adjustments, (2) ratio analysis, (3) assessment of accounting quality, and (4) valuation. Hence, De Mello-e-Souza and Awasthi (2009) examines each of these in turn as follows:

(1.) Preliminary data adjustments:

In data adjustments, financial analysts seek to minimize measurement errors by converting financial statements to a common set of accounting rules, recognizing off-balance-sheet items, and distinguishing between necessary and superfluous assets. Standard adjustments include separating transitory from recurring items and distinguishing financing from operating effects. More-complex adjustments include capitalization of operating leases, capitalization of Research and Development (R&D) expenses, and consolidation of subsidiaries accounted for under the "equity method" (De Mello-e-Souza and Awasthi, 2009).

(2.) Ratio analysis:

Ratio analysis involves using ratios of financial statement and market-based numbers to examine companies over time and to compare them with each other in terms of profitability, efficiency and risk. An obvious weakness in ratios is that they presume linear, stationary-parameter, single-equation models of a firm. The advantage of ratios lies in their simplicity and in their power to generate important questions in short order. A good way to understand the story numerous ratios have to tell is to organize them according to the DuPont Model, as follows: Level 1 disaggregates business value in terms of growth, risk, and return on equity; Level 2 explains return on equity as return on assets plus financial leverage; Level 3 looks at return on assets as profitability of sales times asset turnover; Level 4 explains profitability of sales via common-size analysis of income; Level 5 explains asset turnover via turnover ratios for specific assets (De Mello-e-Souza and Awasthi, 2009).

(3.) Accounting Quality Analysis:

Accounting quality is associated with how well a company conveys its performance and financial position to investors by means of accounting reports. Since historical performance is often indicative of prospective earnings, accounting quality is associated with the degree of linkage between changes in reported income and changes in value. Accounting quality is a key concept for executives responsible for certifying that financial statements are "fair and true" and for financial analysts and management accountants who rely on these numbers to make recommendations (De Mello-e-Souza and Awasthi, 2009).

(4.) Valuation.

Financial forecasts supported by the three prior stages lead to fair value estimates. Significant gaps between fair values and market prices hint at important differences between what management and investors expect. Such differences can cause significant losses to investors and may lead to legal action against the company and its executives. Therefore, a thorough analysis of any gaps between market prices and fair values is an indispensable step toward relevant, fair, and transparent disclosures (De Mello-e-Souza and Awasthi, 2009)

In addition, Universal Teachers Publications (2010) defines ratio analysis as one of the techniques of financial analysis to evaluate the financial condition and performance of a business concern, that is, the comparison of one figure to other relevant figure or figures. Besides, Universal Teachers Publications claims that there are various groups of people who are interested in analysis of financial position of a company. They use the ratio analysis to workout a particular financial characteristic of the company in which they are interested.

Advantages of Ratio and Financial Statement Analysis

Therefore, Universal Teachers Publications (2010) outlines and explains that ratio analysis helps the various groups as follows:-

1. To workout the profitability: Accounting ratio help to measure the profitability of the business by calculating the various profitability ratios. It helps the management to know about the earning capacity of the business concern. In this way, profitability ratio show the actual performance of the business

2. To workout the solvency: With help of solvency ratios, solvency of the company can be measured. The ratio shows the relationship between the liabilities and assets. Incase of external liabilities are more than that of assets of the company; it shows the unsound position of the business. In this case the business has to make it possible to repay its loans.

3. Helpful in analysis of financial statement: Ratio analysis helps the outsider just like creditors, shareholders, debenture-holders, bankers to know about the profitability and ability of the company to pay them interest and dividend, among other payments.

4. Helpful in comparative analysis of the performance: With the help of ratio analysis, a company may have a comparative study of its performance to the previous years. In this way, company comes to know about its weak point and be able to improve them.

5. To simply the accounting information: Accounting information: Accounting ratios are very useful as they briefly summarize the results of detailed and complicated computations.

6. To workout the operating efficiency: Ratio analysis helps to work out the operating efficiency of the company with the help of various turnover rations. All turnover ratios are worked out to evaluate the performance of the business in utilizing the resources.

7. To workout short-term financial position: Ratio analysis helps to workout the operating efficiency of the company with the help of various turnover ratios. All turnover ratios are worked out to evaluate the performance of the business in utilizing the resources.

8. Helpful for forecasting purposes: Accounting ratios indicate the trend of the business. The trend is useful for estimating the future. With the help of the previous year's ratios, estimates for future can be made. In this way these ratios provide the basis for preparing budgets and also determine future line of action.

In spite of many advantages, Universal Teachers Publications (2010) establishes that there are certain limitations of the ratio analysis techniques and they should be kept in mind while using them in interpreting financial statement. Thus, Universal Teachers Publications (2010) outlines and explains the main limitations of accounting ratios as follows:

Limitations of Ratio and Financial Statement Analysis

1. Limited Comparability: Different firms apply different accounting policies. Therefore the ratio of one firm can not always be compared with the ratio of other firms. Some firms may value the closing stock on LIFO basis while some firms may value on FIFO basis. Similarly, there maybe difference in providing depreciation of fixed assets or certain provision for doubtful debts etc.

2. False Results: Accounting ratios are based on data drawn from accounting records. In case that data is correct, then only the ratio will be correct. For instance, valuation of stock is based… READ MORE

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