Financial Ratios and Financial Analysis

Financial Ratios/Financial Analysis

Liquidity ratios are ratios or figures, which is used to measure firm’s capacity to pay off its short-term debt commitments. This is performed by measuring firm’s liquid assets (comprising those which may easily be converted into cash) versus its short-term liabilities. Liquidity ratio has some limitations, for instance, analysts use this ratio for making decision concerning liquidity of a company; however, company’s inventories and receivables might be vague if the company’s sales are periodic and/or the firm utilizes a natural business year. Furthermore, liquidity ratios must be considered against ratios demonstrating time it would take to convert assets to cash; however, conversion time of several months compared to a few days would seriously impact liquidity (Peterson & Fabozzi, 2012).

Leverage ratios have limitations for a firm; for example, when a company uses financial leverage they are technically borrowing money. Borrowing funds will develop a cloud whether it is one that generates little shade or that caused thunderstorm. Borrowing funds constantly will potentially create an image that may be of high risk. This can lead to increase in interest rates and some restrictions may be given to the borrowing organization. It can also affect the value of stock, thus leading to drastic drop if stockholders become concerned (Vandyck, 2006).

In activity ratio, data collection is time consuming process and capital expenditure on the activity ratio system and it is ensuing running costs may a problem for companies. This means that, activity ratios will limit the company because it will increase the costs (Vandyck, 2006).

In profitability ratios, manipulation is possible because is founded on investments and earnings. Both these figures may be manipulated by management by adopting unpredictable accounting policies concerning inventory valuation, depreciation, and treatment of provisions. Profitability ratio emphasis on short-term profits because overall it stress the generation of short-term profits thus affecting profitability of the firm. The company may attain this objective cutting down cost like those on development and research or sales promotion. Reducing such costs without any justification might severely impact the profitability of the firm in the long run, although this ratio might show performance in the short run. Furthermore, profitability ratio is poor way of company’s performance because it is also impacted by several inessential and non-controllable factors. Frequently the present return is the outcome of the wisdom or the craziness of the past management. Therefore, the present management cannot take credit or be held accountable for doing of the antecedents. Occasionally low or high profit might due to chance. Profitability ratio in such instance, for judging the financial performance will be more or less irrelevant (Peterson & Fabozzi, 2012).

The company should present to shareholders in form of financial statements key financial ratios for the years 2010 and 2009. They should present market ratios that measure returns to stockholders and the value the market places on firm’s stock. It should also have liquidity ratios that usually measure company’s capacity to meet cash requirements if need be. Activity ratio is also needed that measures the liquidity of definite assets and efficiency of managing those assets. Leverage ratios is also needed that measures degree of company’s financing with equity and its capacity to cover interest and other fixed fees. In addition, profitability ratios is required that measures the overall performance of the company and its effectiveness in managing equity, assets and liabilities (Peterson & Fabozzi, 2012).

References

Peterson, D. P., & Fabozzi, F. J. (2012). Analysis of financial statements.

Vandyck, C. K. (2006). Financial ratio analysis: A handy guidebook. Victoria, B.C: Trafford.