What are Financial ratios?
Although ratios offer valuable information as tools in analyzing financial statements they also have their limitations. Fraser and Ormiston (2010) explained that ratios do not provide all the answers needed to paint a full picture of a company’s financial condition, and although they indicate areas of strength and weakness they are not predictable and should be utilized with common sense (Fraser & Ormiston, 2010). For example, activity ratios help define how many times a company’s inventory is sold and replaced during an accounting period to determine how many days it took to sell the inventory on hand. A low turnover for instance, usually indicates that products are not being moved but does not clarify the reasons to help determine if this is a temporary condition or typical of that product (Ratio analysis: using financial ratios, 2010). Liquidity ratios, in the meantime, are used to measure a firm’s capabilities of meeting short term debts but they do not determine whether there is sufficient cash on hand to satisfy their debt commitments.
Because of the complexities involved in liquidation, quick liquidity ratios offer an alternative way to measure liquidity because it excludes the inventory from the current asset totals. Leverage ratios on the other hand reveal a company’s ability to service their debts.
The advantage of these ratios when used effectively is that shareholder returns are magnified through financial leverage. The disadvantage is that the ratios do not reveal all the risks involved or whether the debt is financed from fixed commitments. In the meantime, profitability ratios reveal the company’s overall efficiency and performance but do not provide the accounting choices and techniques used to calculate the data which can be misleading (Financial Ratios, 2010). In conclusion, when considering financial ratios although they provide valuable information the analyst must always keep in mind that they have their limitations and that using common sense strategies can help them determine a more accurate picture of a company’s financial condition.
Financial Ratios. (2010). Retrieved December 1, 2013, from netmba.com: http://www.netmba.com/finance/financial/ratios/
Ratio analysis: using financial ratios. (2010). Retrieved December 1, 2013, from Investopedia.com: http://www.investopedia.com/university/ratio-analysis/using-ratios.asp
Fraser, L., & Ormiston, A. (2010). Understanding financial statements. Pearson Education.