Understanding the Concept of Financial Ratio & Financial Analysis

Executive Summary

In an economy, managing finance and financial decisions play an important role in the development of business environment. Organisations work hard to attain their set goals. All organisations or business entities are different from one another on the basis of their operations and organisational settings but one thing is common among them, and that is proper management of finance and financial resources. There are various procedures through which a company can provide check and balanced over the usage of its financial resources. From such methods financial analysis and ratio analysis is most effective.

This assignment highlights the importance, benefits and limitations associated with the ratio analysis.

Executive Summary2

Discussion4

Importance of Ratios with Respect to Different Categories5

1)Liquidity Ratios6

2)Turnover Ratios6

3)Financial Leverage Ratios6

4)Profitability Ratios7

Benefits of Using Ratios in Analyzing Financial Statement7

1)Comparison8

2)Industry Analysis8

3)Stock Valuation8

4)Designing Dividend Policy9

Limitation of Ratios9

Conclusion11

References12

Understanding the Concept of Financial Ratio & Financial Analysis

Introduction

Ratio analysis is used for analyses of financial statements to get a quick signal of a company's financial performance in various key areas. They identify trends of a company over a period of time or can be used to compare two companies at a single point in time and eliminate the impact of size of companies to make the comparison meaningful. Ratios are a good way to evaluate the performance of the business and identify problems (Gibson, C., (2012)). They are good indicators of performance as they compared from the current year to those of one or more prior periods. With these ratios the performance of the company is also compared with that of competitors or other companies of similar size engaged in similar activities. The interpretation of financial ratios is fairly straightforward. This is to compare the ratio of your business with the statistics for your industry

Discussion

Financial ratios are very valuable indicators for any company. They indicate clear picture of the financial performance and financial situation of the company within the industry. In short, relationship that shows something regarding the activities of the company, like ratio between the current asset of the company and its current liability or among the debtors and turnovers. On the whole, ratios can be determined from the information that is available in the financial statements. In this section, we are going to discuss four major financial ratios of the company and its importance.

However, the use of ratio analysis may mislead the analyst because of the nature of financial statements. Financial statements are prepared on the basis of accrual basis of accounting. Many items other than cash and short term debt is open to manipulation and depend on estimates such as depreciation methods, inventory valuation methods, bad debts expense etc. Apart from that fixed assets are reports at historical cost rather than fair value. Inflation is another factor that can distort the ratios. Ratios themselves give no indication until they are compared to industry benchmarks which are not always easy to obtain and many companies may be going through different phases of their lifecycles ...