FINC300-8

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300

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Finance

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Jan 9, 2024

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Financial Ratios and Analysis Financial Ratios and Analysis The purpose of this research is to review financial ratios and financial analysis and their importance. This research will also cover the financial ratio analysis limitations. The financial ratios, including stockholders, short-term lenders, and long-term lenders, will be evaluated with examples of which ratio each would prefer. Financial ratios are used to aid investors and companies in analyzing and comparing relationships of differing financial information over an entire business sector, industry or history of an individual company (Carlson, 2019). A financial analysis evaluates budgets, business projects, and other finance-related dealings, which will ultimately uncover the suitability and overall performance of a company (Tuovila, 2020). A financial ratio analysis is a tool that helps look at a company’s financial statements and compare a line-item data to reveal insight on solvency, operational efficiency, liquidity, and profitability (Bloomenthal, 2020). Purpose and Importance of Financial Ratio The purpose of a financial ratio is to look at differing financial information and analyze and compare relationships. Analysts are able to calculate financial ratios by numbers taken from income statements, balance sheets, and cash flow statements (Carlson, 2019). These numerical values provide information about a company. A quantitative analysis for financial ratios to determine a company’s profitability, growth, valuation, liquidity, rates of return, leverage, and more (CFI Education Inc., 2020). Financial ratios are categorized into five separate groups: profitability ratios, leverage ratios, liquidity ratios, market value ratios, and efficiency ratios (CFI Education Inc., 2020). Financial ratios are good when comparing competing companies. This helps a company strategically plan based upon their strengths, weaknesses, and advantages over competitors. Financial ratios help a company perform internal and external analyses that help 1
Financial Ratios and Analysis track performance. These analyses contribute into measuring performance compared to competitors. Purpose and Importance of Financial Analysis A financial analysis is an important process that helps evaluate a company’s performance and suitability through evaluating business projects, budgets, and other financial transactions (Tuovila, 2020). This helps determine if an entity is stable, solvent, liquid, or profitable enough to potentially invest in (Tuovila, 2020). This analysis builds long-term plans and identifies projects or companies for investment, while setting financial policy, and evaluating economic trends (Tuovila, 2020). A financial analysis involves numbers and data; an analyst for both corporate and investment finance thoroughly reviews this information (Tuovila, 2020). The accounting department shares a financial analysis with management in order to improve business decisions, which is used in corporate finance (Tuovila, 2020). An internal analysis may include present value and the internal rate of return rations to determine if a project is worth pursuing (Tuovila, 2020). One of the main benefits to a corporate financial analysis is to explore a company’s past performance to identify seasonal trends (Tuovila, 2020). An investment financial analysis is approached with a top-down or bottom-up technique (Tuovila, 2020). The top-down approach relies on macroeconomic opportunities and narrows down to determine the best company within that sector (Tuovila, 2020). Afterwards, specific companies take further analysis of stocks that have potential success evaluated by a company’s fundamentals (Tuovila, 2020). The two types of There are two different types of financial analyses: fundamental and technical. A fundamental analysis takes data of financial statements to find ratios (Tuovila, 2020). On the contrary, a technical analysis gathers trading activity to utilize statistical trends(Tuovila, 2020). 2
Financial Ratios and Analysis Limitations of Financial Ratio Analysis A financial ratio analysis is a common tool used to helps a business make critical financial decisions. However, a ratio analysis does not take the size of the business into account. A ratio analysis disregards the resultant bargaining power, the business size, and the economies of scale enjoyed by large businesses rather than small businesses (CFA Institute, 2020). A ratio analysis fails to consider the contingent liability. A contingent liability is dependent on outside factors that could or could not occur, such as litigation matter (CFA Institute, 2020). Another limitation to a ratio analysis is that it does not involve the accounting policies’ impact adopted by the business in acknowledging income and expenses (CFA Institute, 2020). This limitation results in a biased and inaccurate comparison between two businesses. A ratio analysis is unrivaled if there is a substantial change in the policies and accounting procedures accepted by the business (CFA Institute, 2020). A financial ratio analysis is limited to comparing different industries. Ratio analysis standards differ across industries which makes comparing companies based on standard financial ratios difficult (CFA Institute, 2020). Other limitations of financial ratio analysis include being based solely on historical figures, not considering the impact of inflation, failing to consider market conditions’ impact, not recognizing the seasonality’s impact, and considering the position of the business on a particular date (CFA Institute, 2020). A financial ratio analysis mainly focuses on the quantitative component of a business and disregards the qualitative aspects. Users of financial ratios The measure of the financial position of a company is called financial ratios. Many people who are having better shares in the company use these ratios. They may be subdivided into shareholders, long-term lenders, and short-term lenders. Liquidity ratios focus on a firm's 3
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Financial Ratios and Analysis ability to pay its short-term debt obligations (Carlson, 2019). Investors who are short-term lenders provide cash or supply materials for no more than a year. The purpose is to measure the company’s performance through liquidity and profitability ratios, such as gross and net profit ratios, current ratios, working capital position and quick ratios, as well as interest coverage and other operating ratios. The financial leverage ratio, otherwise known as debt ratios, focus on a whether or not the firm has the ability to meet its long-term debt obligations (Carlson, 2019). Long-term lenders provide long-term loans and company assets which may include financial institutions and banks. These lenders are concerned with having ratios including turnover, leverage, stability, and liquidity ratios. The legal owners of the company are the shareholders, so their main focus is on the profitability ratios. Profitability ratios are a group of financial metrics that display a company’s ability to produce earning compared to its associated expenses (Maverick, 2020). Shareholders also focus on the leverage ratios, the pay-out ratio, the price earnings ratio, the dividend yield ratio, and the liquidity and stability ratios such as capital gearing ratio, proprietary ratio, and debt-equity ratio. Conclusion Financial ratios are good tools for quantitative analysis. This technique allows a business to benchmark itself compared to competitors and understand its strengths, weaknesses, and opportunity. However, financial ratio analysis has limitations and mainly focuses on the quantitative side of a business while disregarding the qualitative factors. Ratios are important tools that business professionals can use to assess performance and make business decisions. These ratios help a business determine where they can enhance the company. Ratios could be divided: short-term lenders would focus upon liquidity ratios, long-term lenders would focus upon leverage or debt ratios, and shareholders would focus upon profitability ratios. 4
Financial Ratios and Analysis References Bloomenthal, A. (2020). Ratio Analysis. Retrieved August 26, 2020, from https://www.investopedia.com/terms/r/ratioanalysis.asp Carlson, R. (2019). How Ratio Analysis Can Enhance Your Business Strategy. Retrieved August 26, 2020, from https://www.thebalancesmb.com/what-is-financial-ratio-analysis-393186 Carlson, R. (2019). Ratios to Assess a Company. Retrieved August 26, 2020, from https://www.thebalancesmb.com/categories-of-financial-ratios-393217 CFA Institute. (2020). Limitations of Ratio Analysis: Top 10 Financial Ratio Limitations. Retrieved August 26, 2020, from https://www.wallstreetmojo.com/ratio-analysis- limitations/ CFI Education Inc. (2020). Financial Ratios - Complete List and Guide to All Financial Ratios. Retrieved August 26, 2020, from https://corporatefinanceinstitute.com/resources/knowledge/finance/financial-ratios/ Maverick, J. (2020). Why Do Shareholders Need Financial Statements? Retrieved August 26, 2020, from https://www.investopedia.com/ask/answers/032615/why-do-shareholders-need- financial-statements.asp Tuovila, A. (2020). Financial Analysis Definition. Retrieved August 26, 2020, from https://www.investopedia.com/terms/f/financial-analysis.asp 5