Unlocking Financial Insights: A Comprehensive Exploration of Ratio Analysis in Business Evaluation - Essay Sample

Use of ratios in analyzing financial statements

In accounting, ratio analysis has been applied extensively in assessing the financial statements. The concept is used in comparing line- item information attained from the financial report of a specific organization. The analysis is used to realize insights related to liquidity, profitability, solvency, and operational efficiency. Ratio analysis can be used to mark how the organization performs over a specific period when comparing the performance of the selected organization to another within the same sector or industry (Quesada- Pineda, 2019). Therefore, the management can use the identified details to realize the market gap and evaluate the competitive advantage. The recognized competitive advantage is further used to strengthen, achieve objectives, and understand weaknesses.

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Benefits of ratios when analyzing balance sheets

The balance sheet accounts are used extensively to assess the enterprises’ sustainability in long term conditions. The ratios are used in the assessment of the balance sheet accounts since they give simplified information. It would be influential in comparing the financial information of different organizations (Prazak & Stavarek, 2017). It would be useful in analyzing trends that include comparing an organization’s balance sheet over a specific period.

Benefits of ratios when analyzing an income statement

When applied in evaluating the income statements, the ratio analysis practices would be advantageous since it would be applicable invalidating or disapproving the investment, financing, and operation discussions of the company. The concept of ratio analysis can also be applied in summarizing the income statement into comparative figures, therefore, assisting the management in evaluating and comparing the financial positions of the organization and the outcome of the decisions made (Arkan, 2016). Also, the ratios would be applied effectively since it helps the organization realize significant information in a simple form where the user can understand the income statement of the organization through reviewing few numbers instead of the full report.

Benefits of ratios when analyzing cash flow statement

The ratios are beneficial when analyzing the cash flow statement since it assists the stakeholders to compare and understand the numbers presented in the cash flow statements. Therefore, the stakeholders would quickly generate essential conclusions on the organization’s performance on a specific period relating to the cash flow statement (Arkan, 2016). The information would, therefore, be used effectively to develop an effective strategy for the performance of the organization to increase the cash flow contents.

Selection of key ratios

In the financial analysis practices, five basic financial ratio analysis types are applied significantly to determine the detailed economic contexts of the organization. Therefore, if choosing the most effective kind of ratio, using the working capital ratio and quick ratio would be the most interesting. The quick ratio is also known as the acid test since it subtracts the inventories from the existing assets before figures are divided into liabilities (Linares- Mustaros et al.,. 2018). The idea of a quick ratio would be advantageous since it is applied in showing how the current liabilities are covered by the cash and the items of reading cash values. The working capital ratio, on the other hand, would be applicable in representing the ability of the organization to spend the current assets in paying out the liabilities. Therefore, the working capital ratio is considered essential since it measures the financial health measured by the creditors to pay off the available depts (Linares- Mustaros et al., 2018).

Dangers of analyzing using ratio analysis

When a company adopts the concept of ratio analysis to assess its financial statements, it is also exposed to some degrees of danger and limitations. For instance, the company is exposed to the historical information where the information used for the assessment depends on the past outcomes released by the organization (Arkan, 2016). Therefore, the metrics of the ratio analysis does not present the future performances of the company. Inflationary effects are also some of the dangers that the company is exposed to when using the financial ratio analysis. If the inflammation occurs at the time of the financial statement releases, the real ratios might not reflect the released financial statement (Arkan, 2016). Therefore, the numbers across the different periods cannot be compared until the inflations are adjusted.

Pitfalls for shareholders, owners of small companies, and banker assessing risks

Even the most dedicated shareholders, owners of the small companies, and banker assessors experience difficulties preparing and evaluating the financial statements. The financial statements hold keen insights about the organization’s performance. However, when data errors and mistakes are encountered, the shareholders, directors of small companies, and bankers might experience negative effect profitability and resource drainages due to some pitfalls such as misclassification expenses and outdated estimates (Arkan, 2016). The misclassification expenses are attained where the company relies on personnel to manually classify and input the expenses that quickly lead to data errors and misclassification of pitfalls. Therefore, the pitfall can be solved through implementing an automated data entry system that limits the possible human errors in data classifications and entries.

Also, reliance on outdated estimates is considered a risky approach since the assumption and calculations can be used as management tools only when they have the latest information. The data can be used in facilitating decision making, such as determining the optimal points for recognizing revenues in long-term projects and identification of the uncollectible debts (Arkan, 2016). Therefore, implementing the automatic updates to the depreciation schedules would be applicable in stabilizing productivity.

References

Arkan, T. (2016). The importance of financial ratios in predicting stock price trends: A case study in emerging markets. Finanse, Rynki Finansowe, Ubezpieczenia, (79), 13-26. https://wnus.edu.pl/frfu/file/article/view/10315.pdf

Linares-Mustarós, S., Coenders, G., & Vives-Mestres, M. (2018). Financial performance and distress profiles. From classification according to financial ratios to compositional classification. Advances in Accounting, 40, 1-10. https://e-tarjome.com/storage/panel/fileuploads/2019-06-11/1560245382_E11288-e-tarjome.pdf

Prazák, T., & Stavárek, D. (2017). The effect of financial ratios on stock price development.http://iivopf.cz/images/Working_papers/WPIEBRS2017/WPIEBRS_43_Prazak_Stavarek.pdfQuesada-Pineda, H. J. (2019). Analysis of Financial Statements Using Ratios. https://vtechworks.lib.vt.edu/bitstream/handle/10919/93102/CNRE-43P.pdf?sequence=1