Question

“Financial ratios calculated and analyzed in a particular situation depend on the user of the financial statements.”- Expound the advantages and limitations of ratio analysis.

Answer 1

Financial Ratio always judge or do health analysis of any financial Statement of any Organization . With help of Financial ratio , Stakeholders can understand financial position , risk area, growth prospect etc . From Top Line to bottom line , each head wise Financial ratio analysis has impact on financial health analysis . In general we dividend ratio under different category to understand financial health in details like :

1. Common Size ratio
2. Liquidity Ratio
3. Efficiency Ratio
4. Solvency Ratio

Brief note on above   : Common size ratio relates to Balance Sheet as well as Income Statement of any company . Each of the item in the Income statement would be calculated on a % of Total Sales .

Liquidity Ratio represents Current Ratio – Mainly track on Current asst / Current Liability . This is represents Balance Sheet ratio. This ratio represents that Company is managing proper working capital and No point of time current liability crossed Current Asset of the company .

With help of Current asset – we can remove non cash item like Inventory, pre payment to derive Quick Asset ratio .

Most important ratio in PNL –Operating Ratio – Operating Margin – recently EBITDA Margin – this ratio and % will help us to understand whether company is generating enough revenue to cover up direct cost and giving us good margin or excess cost over run , decrease ratio and Margin

Couple of Balance Sheet ratio –

Inventory Ratio – How Quickly Inventory is moving and convert into Finished good

Sales to Receivable ratio – Debtors Turnover ratio- this ration help us to understand how quickly we can collect cash or any blockakge in collection

Return on Asset- to understand whether present Asset is giving us good return or Not .

Net Sales to Working Capital Loan

Debt to Equity Ratio- Always help us to understand movement of Debt and Equity and understand whether Equity is enough to cover up debt

Net Debt to Equity – Net Debt mean – Total Debt – Cash /Cash Equivalent   . This ratio also help us to understand whether Equity fair enough to cover Net Debt of the company

Working Capital loan , Net Sales to Working Capital Loan – complete picture of working capital and revenue generatiin is fair enough to cover up working capital

EV / EBITDA ratio – EV – Enterprise value – Total Market capitalization+ Total borrowings – Cash payment

The limitation of Ratio Analysis

Major road block in Ratio analysis is consider that information used in ratio analysis derived from actual historical result

Inflation rate impact on Ratio analysis – if the rate of inflation has changed in any of the periods , then number are not comparable .

Operational Change –any major change in Organization structure , which disturb ratio analysis

Accounting Policy –Like One company follow Unit cost of production method depreciation and other company based on Straight Line depreciation . So different company having different accounting policies which will disturb ratio

Company Strategy –Same type of Industry but different strategy will lead to provide different ratio . One company is following low cost strategy , so willing to accept low Margin while other company in same Industry high price base and expect high margin

Point in time – This is most dangerous factor in case of Balance Sheet ratio. Information in Balance sheet always