Ratio analysis is a useful tool for the purpose of financial analysis as it facilitates summarization of a large quantitative data and produces a meaningful conclusion for every user and the same is discussed below:
- Owners: Ratios are used by the owners of the company so as to know about their liquidity, efficiency and profitability of their entity. In other words, ratios act as profile evaluators on the basis of which owners establish benchmarks for the future performance of the company.
- Financial managers: Finance managers use the ratios to evaluate the financial policies of the company and ensure that all the resources of the company are efficiently deployed.
- Investors: Investors and creditors are another prime users of the ratio analysis as they consider the ratio outcomes in relation to their decision to invest in the company. Since both investors and creditors are concerned about return and margins of the company, they thoroughly study and interpret the ratio outcomes before investing their funds in the company.
However, even the ratio suffers the limitations and do not tell the whole story because of following reasons:
- Ratios are not valid when used in isolation as they make sense only when compared to other firms or to the company’s historical performance.
- Conclusions cannot be made from viewing only one set of ratios i.e all ratios must be relative to one another.
- With use of different accounting standards, comparison among companies on the basis of financial ratios is difficult.
Thus, citing above limitations of ratio analysis, we can infer that in order to obtain a meaningful analysis, we also need to supplement financial analysis data with non-financial considerations because evaluating a company’s performance through ratio analysis always focus on annual or short term performance against accounting yardsticks. Thus, no consideration for customer satisfaction and competitors is accounted for which are also important to achieve long term profitability and to achieve long term strategic goals. Thus, supplementing financial data with non-financial measures create a well needed link to long term organizational goals.
Liquidity ratios are important and meaningful ratio sets as they indicate about the ability of the company to pay its short term obligations. Higher the multiple of liquidity ratio more liquid is the entity and vice versa.(Walther, 2012)
Generally two liquidity ratios are used by the analyst to know about the liquidty position of the company:
- Current Ratio
- Quick Ratio/Acid Test Ratio
Current Ratio: Current Assets/ Current Liabilities
Quick Ratio: Also known as Acid Ratio, this ratio is a more stringent ratio set as it excludes inventories from the total current assets. The average industry quick ratio is 1:1.
Quick Ratio: (Current Assets – Inventory)/ Current Liabilities
Use by Investors:
Liquidity Ratios can be used by the investors to judge as how strong are the liquidity roots of the company. For instance if current ratio of any company is less than one(1), it indicates that the firm has negative working capital and is surely facing liquidty crisis and thus it gives a straight-forward advice that the company is not a suitable investment.
Reference:Walther. (2012). Principles of Accounting: Volume I. San Diego, CA: Bridgepoint Education, Inc.