Ratio and Financial Statement Analysis

Topics: Financial ratio, Financial ratios, Financial statements Pages: 6 (1527 words) Published: August 5, 2014

Financial Decision Making for Managers

Spring 2011-2012

Ratio and Financial Statement Analysis

Benefits and Limitations.

Executive Summary

This paper analyzes tools used in financial analysis such as ratios. Financial ratio analysis is a judicious way for different stakeholders to use for different goals.

This paper demonstrates that financial ratio analysis is an important instrument to estimate resources and their used. It also demonstrates that despite the fact that financial ratio analysis is an excellent tool, it does have constraints. In fact, we will examine financial ratio by analyzing they limitations and they benefits.

References used in this paper are from books and journal in a scholarly journal. Presentation of the data and the methodology used are objective; they are supported by cases.

Is it possible to estimate or evaluate a company’s present and future performance? The answer is yes, but you need tools and learn how to use them. Financial ratio analysis is an excellent tool for companies to evaluate their financial health in order to identify feebleness so as to institute corrective measures. Financial ratios are first and foremost manager’s concern because they want to determine what divisions have performed well. It is as well stockholders’ concern because they want to know the value of their stock. Financial ratio is used by creditor to determine whether they will receive the money the loaned to the firm (Parrino, Kindwell, & Bates, 2011).

“Financial analysis is used to analyze whether an entity is stable, solvent, liquid, or profitable enough to be invested in” (Financial Analysis, Investopedia). The purpose of financial statement analysis is to help users in predicting the future. In other words, ratios are highly important profit tools that help to implement plans that improve profitability, liquidity, financial structure, reordering, leverage, and interest coverage. (Anonymous, 2000). Ratios are often able to help predict performance as well as provide indications of many potential problems. Despite the fact that financial ratio analysis can provide imminent problems of the company’s performance, some important limitation should be noted when using financial ratios. In fact, most financial ratios don't tell the full story.

This paper will analyze the benefits and limitations of ratio analysis, explaining what factors impact the meaningfulness of such measures.

Financial ratio analysis is a useful tool for users of financial statement. According to parino et al (2011), ratio analysis simplifies the comprehension of financial statements. They inform the financial variation of the business. Thus, one of the advantages of using this tool is to acquire information about a business. For instance, the total debt ratio shows the use of debt in a firm’s capital structure. The higher the debt ratio, the more debt the company has.

Another benefit of using ratio analysis is that they facilitate comparison between different businesses, and between firms which differ in size. As an illustration, let compare the Price-Earning ratio (P/E) of two companies with different business. Recall that P/E ratio is the ratio most people are familiar with and helps one determine whether or not a stock is too expensive or a really good deal by looking at the earnings relative to stock price (Siegel, Shim, 2000).

Company 1, McDonald’s CorporationCompany 2, Apple Inc

Price/Earning RatioPrice/Earning Ratio


Data retrieve from http://www.nasdaq.com/symbol/aapl/pe-ratio

As shown above, the ratio helps to gauge the trends of price-earnings of these for two different companies with different business; thus, the P/E ratio may help an investor to make decision.

Financial ratio can also bring to light a...

References: “Ratios are only as good as the data upon which they are based and the information with which they are compared.” (Kieso, Weygandt, Warfield, 2010) Thus, ratios analysis present some disadvantages.
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