Accounting and financial management have often been regarded as the most complex aspects of managing a business. The numbers are usually big, the formulae confusing and there are so many regulations. It is fine for the Director of Finance/CFO and his/her team but what about the other stakeholders, especially average investors and the managers actually running the show. How can they ensure that their investment is safe or their performance is in line with organizational goals?
Financial ratios provide a quick and comparable view of the performance of a business - by using financial ratio analysis, a lot of seemingly complex and overwhelming accounting information and year-end reporting can be made easy to comprehend. It may not be easy to adjudge the performance of a company over a period of time, say over five years or compare the same with a competitor or industry peer by looking at the year-end reporting, at least for an average investor. However, the use of financial performance ratios makes this possible. Financial analysts at business channels and newspapers use these to recommend one stock over the other. Stakeholders and the Board keep a close watch on these in order to ensure that the management is doing its job properly.
Use and Limitations of Financial Ratio Analysis
However, one must keep in mind the following issues when using financial ratios:
- One of the most important reasons for using financial ratio analysis is comparability and for this, a reference point is required. Usually, financial ratios are compared to historical ratios of the business itself, competitor’s financial ratios or the overall ratios of the industry in question. Performance may be adjudged as against organizational goals or forecasts.
- A number of ratios must be analysed together to get a true and reliable picture of the financial performance of the business. Relying on each ratio individually may not be a good strategy.
- Year-end values may not be truly representative of the actual performance of the business and hence, average values should be used when they are available.
- The limitations of accounting methods also apply to financial ratio analysis. The selection and application of accounting standards may result in different ratio values.
Financial ratio analysis, in fact, has a great use in management accounting which differs from financial accounting in being an on-going, performance management exercise.