Its importance lies in the fact that it presents facts on a comparative basis and enables drawing of inferences as regards a firm's performance.
It is relevant in assessing the firm's performance in the below mentioned aspects :
I) Financial ratios for evaluation of performance :
Liquidity position : Ratio analysis assists in drawing conclusions as regards the firm's liquidity position. It would be satisfactory if the firm is able to meet its current obligations when they become due.
A firm can be said to have the ability to meet its short-term liabilities if it has sufficient liquidity to pay interest on its short-maturing debt, usually within a year as also the principal. This ability is reflected in the liquidity ratios of the firm and liquidity ratios are useful in credit analysis by banks and other suppliers of short-term loans.
Long-term solvency : Ratio analysis is equally helpful for assessing a firm's long-term financial viability. This aspect of the financial position of a borrower is of concern to the long-term creditors, security analysts and the present and potential owners of a business.
The long-term solvency is measured by the leverage/capital structure and profitability ratios focusing on earning power and operating efficiency and ratio analysis reveals the strength and weaknesses of a firm in respect thereto.
The leverage ratios, for example, indicates whether a firm has a reasonable proportion of various sources of finance or whether heavily loaded with debt in which case its solvency is exposed to serious strain. In the same manner, various profitability ratios reveal whether or not the firm is able to offer adequate return to its owners consistent with the risk involved.
Operating efficiency : Ratio analysis throws light on the degree of efficiency in the management and utilization of its assets. Various activity ratios measure this kind of operational efficiency, a firm's solvency is, in the ultimate analysis, dependent on the sales revenues generated by the use of its assets - total as well as its components.
Over-all-profitability : Unlike outside parties, that are interested in one aspect of the financial position of a firm, the management is constantly concerned about the overall profitability of the enterprise i.e. they are concerned about the firm's ability to meet its short-term and long-term obligations to its creditors, to ensure reasonable return to its owners and secure optimum utilization of the firm's assets. It is possible if an integrated view is taken and all the ratios are considered together.
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Inter-firm comparison : Ratio analysis not only throws light on the firm's financial position but also serves as a stepping stone to remedial measures. It is made possible by inter-firm comparison/comparison with industry average.
It should be reasonably expected that the firm's performance is in broad conformity with that of the industry to which it belongs. An inter-firm comparison demonstrates the relative position vis-à-vis its competitors. If the results are at variance either with the industry average or with that of the competitors, the firm can seek to identify the probable reasons and in its light, take remedial measures.
Ratios not only perform post-mortem of operations, but also serves as barometer for future, they have predictory value and are helpful in forecasting and planning future business activities and helps in budgeting.
II) Financial ratios for budgeting :
In this field ratios are able to provide a great deal of assistance, budget is only an estimate of future activity based on past experience, in the making of which the relationship between different spheres of activities are invaluable.
It is usually possible to estimate budgeted figures using financial ratios. Ratios also can be made use of for measuring actual performance with budgeted figures and indicate directions in which adjustments should be made either in the budget or in performance to bring them closer to each other.
Limitations of financial ratios are as follows :
- Diversified product lines : Many businesses operate a large number of divisions in quite different industries. In such cases ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.
- Financial data are badly distorted by inflation : Historical cost values may be substantially different from true values, such distortions in financial data are also carried in financial ratios.
- Seasonal factors may also influence financial data.
- To give good shape to the financial ratios used popularly : The business may make some year-end adjustments, such window-dressing can change the character of financial ratios that would be different had there been no change.
- Differences in accounting policies and accounting period make the accounting data of 2 firms non-comparable as also the accounting ratios.
- There is no standard set of ratios against which a firm's ratios may be compared, sometimes, if a firm decides to be above average then, industry average becomes a low standard. On the other hand, for a below average firm, industry averages become too high as standards to achieve.
- It is difficult to generalize whether a particular ratio is good or bad, for instance, a low current ratio may be 'bad' from the view point of low liquidity, while a high current ratio may be 'bad' as it may result from inefficient working capital management.
- Financial ratios are inter-related and not independent, when viewed in isolation one ratio may highlight efficiency but, as a set of ratios it may speak differently. Such interdependence among the ratios can be taken care of through multivariate analysis. Financial ratios provide clues but not conclusions.
These are tools in the hands of experts as there is no standard ready-made interpretation of financial ratios.
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