1. NAME :NYAKUDANGA SIMBARASHE LAWRENCE
REG. NUMBER : C13121559X
SCHOOL : BUSINESS SCIENCES AND MANAGEMENT
PROGRAMME : ENTREPRENEURSHIP AND BUSINESS MANAGEMENT
MODULE : FINANCIAL MANAGEMENT (CUAC 218)
LEVEL : 2:1
LECTURER : MR MBIZI
QUESTION : The usefulness of financial ratio analysis in the evaluation of a firm’s
performance is severely limited by a number of factors…” Discuss this statement in
relation to the importance of ratios in assessment of a firm’s performance.
2. Financial ratios are a set of tools prepared from the accounts of a firm that enable the analysis
of the firm’s performance. Financial ratio analysis has been used to assess company
performance for almost as long as modern share markets have been around.(D’Amato
E;2010).The aim of this presentation is to discuss the factors that limit the usefulness of these
financial ratios and on the other side their importance in the analysis of a firm’s performance.
Before the subject matter is discussed, some of the various financial ratios are explained
below.
Liquidity ratios indicate whether a company has the ability to pay off short-term debt
obligations (debts due to be paid within one year) as they fall due (Auerbach A.; 2005).
Generally, a higher value is desired as this indicates greater capacity to meet debt obligations.
Leverage ratios, also referred to as gearing ratios, measure the extent to which a company
utilises debt to finance growth (D’Amato E; 2010). Leverage ratios can provide an indication
of a company’s long-term solvency.
Profitability ratios measure a company’s performance and provide an indication of its
ability to generate profits. As profits are used to fund business development and pay
dividends to shareholders, a company’s profitability and how efficient it is at generating
profits is an important consideration for shareholders.
Valuation ratios are used by investors to determine whether the current share price of a
company is high or low in relation to its true value. Valuation ratios also help us assess if a
company is cheap or expensive relative to earnings, growth prospects and dividend
distributions. (Gill J.O.; 1992)
FACTORS THAT LIMIT THEIR USEFULNESS:
Inflation
Inflation may have badly distorted a company's balance sheet. In this case, profits will also be
affected. Thus a ratio analysis of one company over time or a comparative analysis of
companies of different ages must be interpreted with judgment. Take the case in Zimbabwe
in the period 2002-2009, inflation had badly affected the country and thus affected the
accounts of many firms in the country. This therefore made financial analysis of firms
difficult and thus limiting the usefulness of ratios in financially analysing a firm’s
performance.
3. Seasonal Factors.
Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a
business can reduce the chance of misinterpretation. For example, a retailer's inventory may
be high in the summer in preparation for the back-to-school season. With these seasonal
variations in the operations and performance of a firm, it will be difficult to judge the firm’s
performance over a long period of time due to these fluctuations in business activity.
Therefore, the use of financial ratios to analyse a firm’s may be limited to some extent.
Different Industries.
Many large firms operate different divisions in different industries. For these companies it is
difficult to find a meaningful set of industry-average ratios. For example, we may want to
compare the performance of Econet Wireless Zimbabwe and Unilever. These firms operate in
different industries and they also use different accounting practises that result in variations in
their accounts and ratios as well. Different accounting practices can distort comparisons even
within the same company for example, leasing versus buying equipment or LIFO versus
FIFO.As a result, it is difficult to compare performance of such firms thereby limiting the
extent to which ratio analysis is important.
The Ratios May Be Conflicting.
A company may have some good and some bad ratios, making it difficult to tell if it's a good
or weak company. For example, a firm may have a good profitability ratio but an adverse
leverage ratio. With this in place, it makes it difficult for the management to know the exact
position of the firm and may have to undertake other tedious processes to know the exact
position and performance of the firm. In this light, ratio analysis may prove to be limiting in
analysing a firm’s performance both in the long and short run.
Despite the above limiting factors to the usefulness of ratio analysis, ratio analysis is an
important tool for analysing the company's financial performance. The following are the
importance of accounting ratio analysis in analysing a firm’s performance.
Analysing Financial Statements
Ratio analysis is an important technique of financial statement analysis. Accounting ratios are
useful for understanding the financial position of the company. Different users such as
4. investors, management, bankers and creditors use the ratios for example leverage and
profitability ratios to analyse the financial situation of the company for their decision making
purposes.
Judging Efficiency
Accounting ratios are important for judging the company's efficiency in terms of its
operations and management. They help judge how well the company has been able to utilize
its assets and earn profits. Take for example the Return on Capital Employed ratio, it helps
the firm to judge their performance on the returns they have yielded from the capital they
gave invested in their operations or projects. This makes ratio analysis an important tool in
analysing the performance of a firm.
Locating Weakness
Accounting ratios can also be used in locating weakness of the company's operations even
though its overall performance may be quite good. Financial ratio is a mathematical tools
which help to financial analyst to judge weakness and strong area of a firm and help to
formulate financial goal of the firm. Financial ratio pin points inventory position, firm
solvency position, its management position and asset management of the enterprise.
Management can then pay attention to the weakness and take remedial measures to overcome
them. Therefore, ratio analysis is an important tool in analysing a firm’s performance as it
also highlights certain areas that need special attention.
Formulating Plans
Although accounting ratios are used to analyse the company's past financial performance,
they can also be used to establish future trends of its financial performance. As a result, they
help formulate the company's future plans. For example the profitability ratios, they can help
the firm decisions such as those of investing in new projects or acquiring more finance to
finance the losses they have incurred.
Comparing Performance
It is essential for a company to know how well it is performing over the years and as
compared to the other firms of the similar nature. Ratio analysis helps in inter-firm
comparison by providing necessary data. An interfirm comparison indicates relative position.
It provides the relevant data for the comparison of the performance of different departments.
5. If comparison shows a variance, the possible reasons of variations may be identified and if
results are negative, the action may be initiated immediately to bring them in line. Ratio
analysis facilitates such comparison thus making it an important tool in analysing a firm’s
performance over time.
Operating Efficiency
Yet another dimension of usefulness or ratio analysis, relevant from the view point of
management is that it throws light on the degree efficiency in the various activity ratios
measures this kind of operational efficiency. Efficiency ratios help with such information and
this can also be used in improving the firm’s performance and efficiency. This makes ratio
analysis an important tool in analysing a firm’s performance.
It Is Helpful In Budgeting and Forecasting
Accounting ratios provide a reliable data, which can be compared, studied and analysed.
These ratios provide sound footing for future prospectus. The ratios can also serve as a basis
for preparing budgeting future line of action making ratios important.
Overally, ratio analysis is an important tool and the basis of analysing and judging a firm’s
performance be it internally or externally with other firms in the same industry or outside the
industry. Though it may be limited by such factors as those listed above, ratio analysis still
serve an important role in analysing the performance of any firm.
6. REFERENCES.
Auerbach A. (2005); Business Builder: How To Analyse Your Business Using Financial
Ratios
Brealy R.M, Allen S.F (2010); Principles Of Corporate Finance; McGraw-Hill Higher
Education 10th
Edition; New York
D’Amato E (2010); The Top 15 Financial Ratios; Lincoln Pty Ltd.
Gill J.O. (1992); Practical Financial Analysis; Koyan Page and Limited
Tondhlana A. (2013); Fundamentals of Corporate Finance; Word Publishers
