Essay Example on Importance of Financial Ratios and Financial Analysis

Financial ratios are an essential tool for investors when evaluating the financial health of an enterprise. Ratios help financial analysts to assess the performance of a company. Financial ratio analysis gives the management the ability to make the right decisions regarding any investment they need to venture into. Financial statements and balance sheets are the major sources of data used in financial ratio analysis. An analyst should have the ability to gather information about the firm’s competitors, economy, and industry. Gathering the additional information will help make valid conclusions about the strengths of the company. Financial ratio analysis information is useful to an enterprise and third parties, although it faces various limitations.

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Financial ratios and financial analysis serve various purposes and present enormous significance to business enterprises. Financial ratio analysis aims to provide investors and third parties with information about a firm to aid their decision (Mohan, 2020). The information helps evaluate a firm’s ability to meet its financial liability. Ratio analysis of past performance help companies in budget preparation. The management can anticipate what to expect in the next financial year and thus gather the items required for budget preparation. Ratio analysis help study trend analysis of a company (Mohan, 2020). Trend analysis helps compare the performance of the firm over the years with the standard ratio and be able to show how the firm is generally doing. Ratio analysis indicates the ability of the management to utilize its assets. Therefore, management is keen to make efficient use of its assets for the best of the company. Ratio analysis shows the potential of a firm to settle its current and future obligations. Firms capable of fulfilling their obligations within the required time, attract lenders and investors, thus availing enough capital to finance its operations.

Financial ratio analysis is important for the evaluation of enterprises, although they are subject to certain limitations. Data on financial statements may be incorrect (Singh, 2020). Ratios depend on entries made by accountants; thus if wrongly entered, it will lead to wrong conclusions. Not all firms use similar accounting techniques. It is challenging to use ratios to compare two firms that use different accounting procedures to value their stock. The prices of goods keep on appreciating over time (Singh, 2020). This makes it difficult to compare the performance of a firm in different years because fixed assets indicate cost, not their current price market. There is no other method to verify the accuracy of financial ratio analysis. Information obtained from ratio analysis is used for decision making, although there is no other method of ascertaining how to get to the same results. Financial ratio analysis focuses on quantitative attributes (Singh, 2020). Ratio analysis does not consider the qualitative characters of clients which may be significant in the evaluation of their ability to meet their obligations compared to their quantitative aspects. To ensure an effective ratio analysis companies ought to have comparable financial statements.

Short-term lenders

Short-term lenders of companies prefer to use the liquidity ratio of a company. An example of a liquidity ratio is the current ratio (Pawar & Shelke, 2020). A current ratio exhibits a firm’s ability to meet present financial obligation using existing assets. Business enterprises with low current ratio indicate their inability to offset current loans using their assets (Pawar & Shelke, 2020). Short-term lenders will prefer this ratio because it shows whether an enterprise can meet existing debts without requesting for external financial assistance.

Long-term lenders

Long-term lenders are more interested in the solvency ratios of a company. An example of a solvency ratio is the debt ratio (Pawar & Shelke, 2020). Debt ratio evaluates the number of a company's assets financed by loans. Firms with high debt ratios do not attract potential investors nor extra funding. The equity ratio is a compliment of the debt ratio (Pawar & Shelke, 2020). The equity ratio evaluates assets financed by funds of shareholders. Businesses with a high equity ratio show the commitment of owners to the company. Long-term lenders will prefer debt to equity ratio because it points out the risk associated with financing the firm.

Stockholders

Stockholders purchase shares of a firm mainly for capital gain and dividends. Capital gain is whereby the value of a share appreciates, and the stockholder may sell it, thus generating more than they spent. The return is the amount paid after the firm settles its taxes from profits earned (Learning, 2020). Only a proportion of the profits pay dividends while the rest is further used to expand the enterprise. Stockholders' interests are on earnings per share as it is the money available for distribution. This ratio calculates the amount of money every share earns for each stockholder.

In conclusion, financial ratio analysis enlightens investors on the level of risks involved with purchasing shares of a particular firm. This prevents investors from making blind investments and loses their capital. Ratio analysis also helps managers be accountable on how their use assets of a firm. Preparation of budgets prevents embezzlement of a company's funds by the management. Financial analysis indicates how a firm is performing against its competitors in the market. This comparison results in innovation and development of better goods achieving customer satisfaction. The financial analysis allows firms to obtain loans from financial institutions to fund their activities, thus preventing closure of businesses. Shareholders should make it a policy for the management to provide financial ratios analysis every fiscal year.

References

Learning, T. (2020). Shareholders' ratios. Textbook.stpauls.br. Retrieved 20 June 2020, from http://textbook.stpauls.br/Accounts_and_Finance_student/page_117.htm.

Mohan, A. (2020). Financial Statement Analysis: Meaning, Objectives and Techniques. Retrieved 20 June 2020, from https://www.accountingnotes.net/financial-statement/financial-statement-analysis-meaning-objectives-and-techniques/5646

Pawar, S., & Shelke, S. (2020). Study on Significance of Performance Evaluation of Companies as the Base for Retail Stock Market Investments. Studies in Indian Place Names, 40(54), 123-129.

Singh, S. (2020). 9 Major Limitations of Ratio Analysis. Learn Accounting: Notes, Procedures, Problems and Solutions. Retrieved 20 June 2020, from https://www.accountingnotes.net/cost-accounting/ratio-analysis/9-major-limitations-of-ratio-analysis/6247.