This paper examines financial ratio analysis by defining, the three groups of stakeholders that use financial ratios, the five different kinds of ratios used and their applications, the analytical tools used in analysis, and finally financial ratio analysis limitations and benefits. The paper illustrates that financial ratio analysis is an important tool for firm’s to evaluate their financial health in order to identify areas of weakness so as to institute corrective measures. While financial ratio analysis does contain limitations that include little theory to guide them as well as the use of accounting data based on historical costs that may not reflect a firm’s true economic conditions, it is an excellent tool for different stakeholders to use for different goals that will remain in use in the area of financial management.
Companies prepare and furnish financial statements on a regular basis to their stakeholders that report on their financial standing. However, the accounting information by itself is not easily analyzable and effective in determining how a particular company is doing financially by itself or in relation to others in the industry. Financial ratio analysis is the use of financial statements to evaluate a company’s overall performance and assess its strength and shortcomings (Jiambalvo, 2009). It is a tool used to evaluate the overall financial health of firms and is approached from different perspectives by creditors, managers, and stockholders. The three different groups are all interested in the profitability of the firm but take on different perspectives. Stock holders invest in firms with the intention of maximizing the value of their stock, earning dividends, and generally maximizing their return on investment. Managers are responsible for the day to day running of the firm and have a fiduciary responsibility to the owners to make decisions that are in the owner’s best interests. They are therefore interested in the same performance measures as stockholders; profitability, dividends, capital appreciation, and return on investment among other measures (Jiambalvo, 2009). Managers make day to day decisions in the running of the firm and as a result need to evaluate the impact of their decisions to ensure maximization of stockholder wealth. Financial statement analysis is a tool used my managers to evaluate the impact of these day to day decisions. Creditor’s primary concern is whether they will receive interest payments they are entitled to and when they will be paid the money loaned to the firm. Therefore creditors carefully monitor the debt leverage on a firm and whether the firm is generating cash to cover the day to day payments, obligations, and interest and principal payments on long-term debt (Jiambalvo, 2009).
Financial ratios are divided into five categories mainly liquidity ratios that measure the ability of a company to cover its current bills, Efficiency ratios that tell how efficiently a firm is using it assets, Leverage ratios that tell the amount of debt a firm contains in its capital structure and whether it’s able to meet its long-term financial obligations, profitability ratios that focus on a firms earnings and Market value indicators that look at a company based on market data as opposed to historical data used in financial statements (Jimbalvo, 2009).
An important analytical tool that uses financial ratios was developed by Edward I. Altman, Ph.D, known as the “Z score”. It uses five traditional financial ratios mixed with multiple discriminant analysis (IOMA’s report, 2003). Professor Altman, a financial economist and professor at New York University’s stern school of business, developed the model by studying financially troubled manufacturing firms but the model works as well on non-manufacturing firms. The Z score is proven to be 90% accurate in predicting whether a business will fail within a year – and 80% accurate in predicting failure within...