Ratio Analysis – Evaluation — Super Business Manager

Internal Users and External Users of Final Accounts will find Ratio Analysis of great help when making business decisions.

All of the accounting ratios are widely used by several business stakeholders, external business analysts and prospective investors in order to assess:

Profitability. Is profitability of the business rising or falling?
Liquidity. Should suppliers agree to supply to the business?
Efficiency. Are the managers of the business using resources efficiently?
Debt levels. Should lenders lend money to the business?
Investment attractiveness. Should investors invest in the business?

However, Ratio Analysis is not a perfect tool, so care must be taken not to rely too heavily on the results. It is recommended to use Ratio Analysis together with other business tools.

Let’s take a look at the main benefits and limitations of Final Accounts and accounting ratios.

Advantages of Ratio Analysis

Advantages of Final Accounts and accounting ratios include:

Help analyze business performance. Identify trends by comparing ratios over time. Users can compare results with results in past years to see whether the business is doing better or worse. Identify ranks by comparing ratios with ratios of competitors. Users can compare results with similar businesses to see how well a business is doing against competitors.
Analyze profitability with Profitability Ratios. Employees can use ratios to assess job security and possible pay rises. Managers and directors can assess the likelihood of getting management bonuses for reaching profitability targets. They can also use ratios to identify profit areas that need improving in the future.
Analyze liquidity with Liquidity Ratios. Trade creditors look at ratios to ensure that their commercial customers have sufficient working capital to repay them.
Analyze efficiency with Efficiency Ratios. Managers can use ratios to assess how well they have been using the business’s resources over the last year, and comparing with previous years. They can also use ratios to identify resource areas that need improving in the future.
Analyze debt levels with Debt Ratios. Financiers use ratios to consider, if the business has sufficient funds to repay any loans that may be approved, and has appropriate profitability to pay interest on loans.
Analyze investment attractiveness with Investor Ratios. Shareholders use ratios to assess the return of their investment compared with other investments, such as holding shares in other companies or in a bank account.
Gauge future opportunities. Various stakeholders can use a range of ratios to gauge job opportunities, e.g. employees can determine possible pay increases, local residents can expect more job opportunities, managers can estimate the amounts of annual bonus, etc.

On another hand, Ratio Analysis should be used with some reservation as there are quite important limitations to its effectiveness.

Disadvantages of Ratio Analysis

Disadvantages of Final Accounts and accounting ratios include:

Based on the past. Ratios are a historical account of a firm’s performance, hence compare past data while the users of accounts are much more interested how the business will perform in the future. They will not indicate the future financial situation of a business unless it is a forecast or estimation.
Quantitate analysis only. Final Accounts do not include qualitative factors such as strengths and weaknesses of a business, the quality and skills of employees, the level of staff motivation, environmental policies, customer satisfaction, etc. These factors are also likely to affect many aspects of business performance. Qualitative factors are totally ignored in Ratio Analysis. Ratios are only concerned with accounting items to which a numerical value can be given.
Incoherence in accounting practices between businesses. Due to the fact that there is no universal way of reporting company accounts, businesses may use different accounting policies. Also, different business organizations report their financial data in different ways, e.g. different methods of depreciation, different ways to value inventory, different intangible assets, etc. What is more, businesses in different countries (and even within the same country) prepare Final Accounts in different ways. Therefore, it makes comparisons more difficult, sometimes impossible, even as the ratios do not compare like oranges with oranges and apples with apples. And, while some firms practice window-dressing of accounts some other firms do not, but act ethically.
A single ratio result is meaningless. One ratio result is not very helpful at all to allow meaningful analysis to be made. Better if a comparison is made between this one result and either trends (within the same business over time) or ranks (with other businesses during the same time period). Both comparisons need to consider changing circumstances over time that could have affected the ratio results. These factors may be outside the company’s control, e.g. an economic recession, natural disasters, etc.
Does not consider external environment. Businesses are almost often affected by external factors – social, technological, economic, environmental, political, legal and ethical. But, the opportunities and threats that come from the external environment are nowhere to be found in Final Accounts. However, they are almost always an underlying change in the performance of a business, e.g. higher TAXes will reduce profitability while lower TAXes will increase profitability.
Businesses are never the same. Different types of business organizations have many different characteristics. And, it is almost impossible to find two identical companies on the market. So, comparing results from Ratio Analysis of a sole trader with a multinational company could be meaningless. Inter-firm comparisons within the same industry need to be used with a lot of caution.
Ratios themselves will not solve real business problems. Ratio Analysis is a very useful analytical tool to assess the past performance, but it does not solve real business issues, nor fixes underperformance. It can bring to light issues that need to be tackled by managers over time. Also, ratios alone do not necessarily indicate the true cause of business problems. It will be up to the managers to identify causes of a problem using The Fishbone Diagram, and implement effective strategies to overcome them.

In summary, Ratio Analysis provides all business stakeholders and other constituencies who have interest in a business with useful financial data to analyze the business’s performance. Essentially, stakeholders use accounting ratios to support decision-making by judging the relative financial strengths and weaknesses of a business organization.