While financial statements can present a companys current financial health, stakeholders often desire more information from

these reports. Ratio analysis represents a series of mathematical formulas a company can apply to financial statements. While these measurements do provide essential data, there are limitations of ratio analysis. A few of the most glaring limitations include potential flaws in accounting information, the need for a reference point, and the potential for ratios to be completely meaningless. Firms must overcome these flaws in order to prevent the limitations of ratio analysis from entering a companys decision-making process. Accounting information and data are not always flawless. While most accountants work hard to present financial information in accordance with national accounting standards, there may be some flexibility to the guidelines. This flexibility represents the starting point for limitations ofratio analysis. For example, an aggressive income recognition process can present higherprofitability ratios. While this may be true for early ratios, latter ratios calculated under this income recognition process can quickly indicate lower profitability. The purpose of ratio analysis is ultimately the comparison of more than one companys financial data for a given period. It is often difficult to make these comparisons when the financial statements are different or in alternate formats. Therefore, the ratios strip this subjectivity away and leave stakeholders with usable information so long as the limitations ofratio analysis are not present. Use of ratio analysis Ratio analysis is used in accounting, finance and marketing departments in order to make more wellinformed decisions and reasonable forecasts. Uses of ratio analysis vary from creating common size accounting statements to determining the businesss inventoryturnover or tracking the success of a marketing campaign over time. Standard ratios are used for different departments to accomplish specific tasks. Even though the use of ratio analysis is important for a business when making decisions, there are also limitations of using such ratios. Uses of ratio analysis include breaking data down so that it can be compared. When comparing two sets of data, ratios can help bring the numbers to equivalent figures. For instance, if the business wants to compare its monthly cost of goods sold for the past year, it should not look at the raw numbers. Instead, the business should calculate the cost of goods sold as a percentage of the total sales in order to determine if costs truly have increased or decreased. Making forecasts is another use of ratio analysis. Comparing ratios over time can help a business make reasonable predictions about what it should expect in the future if conditions remain the same or similar. Breaking data down to ratios and comparing the ratios over time also can help businesses see if trends or cycles emerge. Standard ratios have been developed to accomplish certain types of analysis within different areas of business. For instance, in finance it is common to use the earnings per share, grossprofit margin, return on assets, and inventory turnover ratios. Not only does this help a business in comparing historical data between itself and competitors, but employees are generally trained in using these specific ratios before being hired. Even though most ratios are easy to compute, the analyst must understand the significance of each ratio in order to avoid making false assumptions. Dangers of using a ratio analysis include not understanding the assumptions made in its calculation, taking into affect price changes, or using data that may be incorrect. Uses of ratio analysis are important in analyzing the businesss data, but they can result in incorrect or misleading calculations. Limitations of the uses of ratio analysis should not prevent businesses from using them, but they should make businesses take more caution before using them in making decisions. For instance, if

the business has changed its prices and is comparing profit ratios over this time period, it needs to take into consideration that the price change may have had an effect on the number of sales.

Trand and ratio analysis Financial analysis often looks at previous information and compares it to current data. This process called trend analysis helps a company understand what it does well and what it does not. The connection between trend and ratio analysis comes from ratios being one tool for conducting financial reviews or profitability analyses. Another use for ratios is to conduct benchmark analysis, where a company compares its financial data to that of another business. Trend and ratio analysis typically occur at month end, year-end, or at any point when a business decides a review is necessary to assess financial information. Trend and ratio analysis use the same inputs: financial statements. These statements represent the final output of the accounting office for a particular time period. Trend analysis typically measures the change in dollars between each line on a financial statement. Another column may list the percentage change between the items as well. This provides a quick view of financial improvement in certain areas of a business. Ratios take a bit more time to compute. Many financial statements used in trend analysis do not have automatic ratios computed by accounting software. Accountants, therefore, need to use a series of mathematical formulas to create the indicators or percentages indicative from ratios. The ratios can, however, draw a connection between trend and ratio analysis. For example, an accountant can keep a record for each ratio computed for a period of time; this then creates a trend for financial comparison. Another connection between trend and ratio analysis is their use for picking stocks. Many investors look for trends on stock price charts as this can provide an indication of when to purchase a stock. Fundamental analysis then requires a look at the company behind the stock. Ratios can help meet this need and match the stock price trend with a financially strong company. One way to complete this analysis is to compute a small set of ratios and determine how well the company operates in terms of profitability, asset turnover, and financial leverage. Ratios also help companies compare themselves to businesses with different operations. For example, a small business is simply unable to have the sales or other operating capabilities of a much larger organization. Ratios, however, strip away these differences and provide indicators that show how well the small business operates compared to the large competitor. The small business can also turn this into a trend and ratio analysis report. This provides information on how the small business can improve itself to be like a much larger operation.

Importance of ratio analysis The importance of ratio analysis is derived from its usefulness as a tool for the assessment of the state of a business by the owners, prospective investors, and people and institutions who may be considering lending money to the business. Ratio analysis is used to calculate or analyze the financial statements generated from a company in a given period. This information is invaluable in terms of its use as an indicator of the position of a company in a competitivefinancial market.

One of the examples of the importance of ratio analysis is its importance as a means for a company to perform an internal evaluation of its performance over a stated period. The information gathered during the ratio analysis allows the company to know whether it has been operating at a profit or a loss as well as the percentage of the profit margin. When the company discovers that it has been operating at a loss, the ratio analysis will allow it to pinpoint the exact sources of the loss. This will allow the business to decide on the best approach for addressing the loss. Another importance of ratio analysis is the fact that it allows a company to compare its performance with that of other companies in the same industry. In the case of huge corporations with different subsidiaries and branches in various locations around the globe, the importance of ratio analysis is clear. Such companies can compare the result of the ratio analysis of the different subsidiaries with the aim of finding out which ones are performing better than the rest. This type of an analysis can be applied toward allocating necessary resources to the under-performing subsidiaries in a more efficient manner. Also, the importance of ratio analysis can be seen in the way it gives potential investors a quick snap shot of the financial condition of a business. Such information may help the investor decide if the business will be profitable or not. If the results of the ratio analysis point toward strong profits, the investor may decide to invest in the business. In the same sense, if the business is not performing well, a prospective buyer may use this information as a bargaining chip to bid a low price for the business. When a bank is considering the possibility of granting a business loan, one of the initial factors it looks at is the ratio analysis of the business. The record of cash inflow and outflow as well as posted profits will help the bank make an informed decision. A positive trend in the ratio analysis is an indication that the business is capable of paying back the loan.

Financial ratio analysis

Financial ratio analysis refers to a quantitative analysis of the ratios that reflect the financial performance of a company. By calculating the ratios of certain items in the companys financial statements, it is possible to compare the performance of two or more companies in the same industry. By this comparison of ratios, investors can determine which companies would be good investments. There are many calculations used in financial ratio analysis, but they can be loosely categorized into four groups: leverage, liquidity and solvency, operating, and profitability. Leverage ratios are indicators of how a company finances its operations. Debt to equity is the key leverage ratio, and it indicates how much debt the company has compared to its equity. A company with a high debt-toequity ratio might be a riskier investment than one with a lower ratio. Liquidity ratios measure how quickly a company can pay off its short term debt. If a liquidity ratio is high, it means that the company is easily able to cover short-term debts. The current ratio, which is current assets divided by current liabilities, is a commonly-used liquidity ratio. The solvency ratio measures a companys ability to meet its long term debt. A higher solvency ratio means that it is more likely that a company will be able to meet its debts and will remain solvent. Operating efficiency is measured by the operational ratio, also called the operating ratio. This ratio is calculated by dividing operating expense by net sales. A small ratio means that the company is better able to continue to be profitable even if revenues decline. A firms profitability can be analyzed

by looking at its profitability ratios. These ratios show how well a company can generate a profit relative to its expenses. Profitability ratios include return on equity, return on assets and profit margin. In order to perform financial ratio analysis, the information used for the calculation of ratios is gleaned from the firms financial statements. These statements include the balance sheet, the income statement and the statement of cash flows. These statements are updated each quarter, and can be found on the companys website and in its annual report. When performing financial ratio analysis, it is important to compare companies that are in the same industry. Ratios can vary widely among industries. For example, a retail company will have much lower profit margin than a technology company. This would result in very different profitability ratios, making a comparison ineffective.

Profitability ratio analysis

Profitability ratio analysis represents mathematical formulas applied to a companys financial statements. The results from these formulas help stakeholders determine how efficiently or effectively a business operates. Return on equity, return on assets, and profit margin are a few of the most common profitability ratios. These formulas measure both profit earned from selling goods and services and the financial returns made by investing money. Companies tend to use profitability ratio analysis as a benchmark tool to assess how well they operate compared to previous periods or a competitor. A companys profit margin is typically the most popular tool used in profitability ratio analysis. The basic formula is sales revenue less cost of goods sold divided by sales revenue. The result indicates what percent of sales a company can expect to remain after paying the inventorycosts for all goods or services sold during a period. This remaining money helps the company pay for any expenses related to generating the sales revenue. Most companies use this formula on a monthly basis in most cases. Return on assets measures net income against the total assets a company has in its operations. Net income is sales less cost of goods sold and total expenses. Total assets represent the book value for all items a company owns as listed on the balance sheet. The return on asset formula is net income divided by total assets. The percentage indicates how well a company uses owned assets to generate profits, with a higher percentage more favorable to the business. A slightly different formula for profitability ratio analysis is the return on equity ratio. This formula divides net income as computed earlier by total stockholders equity. Stockholders equity represents the amount of external investment made into a business by investors. Companies use this ratio to assess how well they use these external funds to incur profit from their business operations. Again, a higher percentage indicates more efficient use of funds and better profitability for the business. Companies must have a defined purpose for profitability ratio analysis. Used alone, these ratios are really quite meaningless as the data does not tell companies very much about their operations. A company may use ratios as goal-setting tools. For example, a company may strive to achieve a 25 percent profit margin on a certain line of goods. Constant assessment of these products using the profit margin formula can help the company determine if it is reaching its goal.