Discuss the validity of the continuing emphasis by companies and analysts on traditional financial ratio analysis. Does this analysis have any part to play in the modern commercial world, or should companies and analysts focus solely on non-financial performance indicators?
Traditional financial ratio analysis is useful as it summarises quite complex accounting information into a relatively small number of key indicators, relating particular figures to one another, and covering profit, liquidity, growth and risk of a company. These financial analyses include:
Profitability ratios; these are concerned with the efficiency of the firm in generating profit and include ROCE, Return on equity ( return on shareholders' funds), Gross profit margin, and Net profit margin. Liquidity ratios; these ratios are used to measure how well the firm is managing its working capital, and include Current ratio, Quick ratio, and Working capital ratios. Activity ratios; these are used to try to weigh up the effectiveness of a firm in using its assets. These are Net asset turnover ratio, Stockholding period, Debtor collection period and Creditor payment period.
Unfortunately ratio analysis is not very accurate; the choice of the ratios which are calculated, the exact definition of these ratios and the conclusions drawn, are very much matters of judgement and assumption. When dealing with ratios, two main limitations arise; to begin with there is a predisposition for the profit and loss account to overstate profit, relative to a more true assessment of the amount of wealth created. Secondly, there is a propensity for balance sheet figures to devalue the amount of capital which is tied up in the firm. This is a particular problem when dealing with ratios which are...