Financial ratio analysis can be helpful if used in conjunction with proper knowledge of factors affecting a business, and not just mechanically
Financial ratio analysis is used to convey the fiscal health and performance of an organisation to various stakeholders such as owners, customers, managers, suppliers, vendors, lenders, regulators and competitors. This is done by analysing information available in a firm’s financial statements.
This system originally started in banks in the US in the 19th Century to gauge the loan repaying capacity of organisations. It was later extended to investors’ decision-making for business purposes using financial ratios. Later, with corporate organisations emerging, the relevance of ratio analysis was understood even more. After the second World War, with the advent of science and technology and increased market competitiveness, new tools and techniques were added to financial ratio analysis. The series of additions and improvements continued in the 1960s well into the ‘90s to come to the existing analysis methods.
Over the years, researchers have continually established the utility of financial ratios in investigating various aspects of business like profitability, solvency and efficiency. It provides trends within organisations by analysing fiscal statements over a large number of financial years (FYs). This is extremely useful to understand the direction of growth of an organisation and identify any trends that affect performance. This type of trend analysis is not possible with the data of a single financial year. Ratio analysis is also crucial to benchmark one’s performance in comparison to industry competitors, identify gaps, assess competitive advantages, strengths, weaknesses, opportunities and threats. This information can be used by decision-makers to improve the organisation’s position in the industry. Ratio analysis is also a tool to discern how efficiently an organisation is using its assets and liabilities and whether the financial resources are over or underutilised. To help managers in their decision-making process, several categories of ratios are used. First, the liquidity quotients like current ratio, quick ratio and cash ratio, measure the ability of an organisation to meet its current liabilities with the use of current assets.
In case an organisation is facing financial trouble in repaying its debt, it is captured in these ratios. Such quotients are used primarily by lenders, bankers and creditors to ascertain an organisation’s capacity to honour its financial commitments. Second, solvency ratios measure the firm’s ability to meet any long-term fiscal commitment and the fact that in the long-term, it owns more than it owes. The solvency of firms is measured by the debt-to-equity and debt-to-assets ratios. Profitability ratios are the third category used to measure the capability of an organisation to earn profits when compared to the costs associated with the business.
A higher profitability ratio, compared to itself in the previous year or its competitor, shows an improvement in fiscal strength. Some important profitability ratios that are used in financial analysis are gross profit margin, net profit margin, return on equity, return on assets and return on capital employed.
Fourth, efficiency quotients like the asset turnover ratio, inventory ratio, fixed assets turnover ratio, working capital turnover ratio, payables turnover ratio and receivables turnover ratio measure how effectively an organisation uses its assets and liabilities to earn revenues and profits. A higher efficiency quotient generally means that the business is more efficient.
Coverage ratios, too, measure an organisation’s ability to cover its debt obligations. A higher coverage quotient shows the ease with which it can service borrowings. Some of the frequently used coverage ratios are debt coverage ratio, interest coverage ratio, fixed charge coverage ratio and EBITDA (earnings before interest, taxes, depreciation and amortisation) coverage ratio. And last but not the least, market ratios help investors to analyse their investments in the organisation and help them predict future stock prices and returns due to dividends. Price-to-earnings, earnings per share, dividend yield and dividend payout ratio are some examples of market ratios.
How is financial ratio analysis changing in the present world order? The trend in today’s times is more predictive in nature and the importance of historical numbers is decreasing by the day. Predictive forecasting models which help in capital budgeting decisions and choices regarding sources of funds and operations have gained more prevalence. The existing business environment is uncertain and volatile with increased focus on people, the planet and sustainability. This is particularly true since the outbreak of the Coronavirus. So, non-pecuniary information that is not reflected in the financial statements is also gaining importance now, which is not replicated in the current ratios used in financial analysis. Globalisation has also increased cross-border transactions, mergers and acquisitions, movement of people and technology transfer, making pecuniary statements more complex than ever. Although financial ratio analysis is important for making decisions, it is not without its limitations. This technique may not give the actual picture when window dressing of statements occurs against financial and business ethics. Ratio analysis techniques may also not give proper results for comparison when different companies use different valuation techniques for inventory and depreciation. Another aspect which goes against ratio analysis is that it just gives the results in numbers and does not reflect the causation factors, which can make these numbers meaningless. Further research should be done to capture the new-age trends in financial ratio analysis to make them even more relevant.
Financial ratio analysis can be a very important analytical tool for business decision-making if it is used in conjunction with a proper knowledge of factors affecting a business and not just used mechanically. If the limitations are considered, they can be very useful to a savvy business manager.
(The writer is Associate Professor, Amity University, Noida. The views expressed are personal)