Significance & Limitation of Ratio Analysis
1. What are the five major categories of ratios, and what questions do they answer? * Liquidity: Can we make required payments as they fall due? * Asset management: Do we have the right amount of assets for the level of sales? * Debt management: Do we have the right mix of debt and equity? * Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in NPM, ROE, and ROA? * Market value: Do investors like what they see as reflected in P/E and M/B ratios?
2. What is the Significance (Importance) of Financial Ratio in Decision Making? * Ratios facilitate comparison of: * One company over time * One company versus other companies * Ratios are used by: * Lenders to determine creditworthiness * Stockholders to estimate future cash flows and risk * Managers to identify areas of weakness and strength
In Detail:
* For Short term Creditors – The Short term creditors like bankers and suppliers of material can determine the firm’s ability to meet its current obligations with the help of liquidity ratios such as current ratio and quick ratio. * For Long Term Creditors – The Long term creditors like debenture-holders and financial institution can determine firm’s long term financial strength and survival with the help of leverage or capital structure ratios such as debt equity ratio. They can know:
i) What sources of long term finances are employed? ii) What is the relationship between various sources of finances? iii) Is there any risk to the solvency of the firm due to the employment of excessive long term debt? * For Management - The Management can determine the operating efficiency with which the firm is utilizing its various assets in generating sales revenues with the help of activity ratios such as capital turnover ratio, stock turnover ratio, etc. Besides this, the management can use the ratios for forecasting purposes also. The Management can better
2. What is the Significance (Importance) of Financial Ratio in Decision Making? * Ratios facilitate comparison of: * One company over time * One company versus other companies * Ratios are used by: * Lenders to determine creditworthiness * Stockholders to estimate future cash flows and risk * Managers to identify areas of weakness and strength
In Detail:
* For Short term Creditors – The Short term creditors like bankers and suppliers of material can determine the firm’s ability to meet its current obligations with the help of liquidity ratios such as current ratio and quick ratio. * For Long Term Creditors – The Long term creditors like debenture-holders and financial institution can determine firm’s long term financial strength and survival with the help of leverage or capital structure ratios such as debt equity ratio. They can know:
i) What sources of long term finances are employed? ii) What is the relationship between various sources of finances? iii) Is there any risk to the solvency of the firm due to the employment of excessive long term debt? * For Management - The Management can determine the operating efficiency with which the firm is utilizing its various assets in generating sales revenues with the help of activity ratios such as capital turnover ratio, stock turnover ratio, etc. Besides this, the management can use the ratios for forecasting purposes also. The Management can better