2.3 Ratio Analysis
There are many relationships between financial accounts and between expected relationships from one point in time to another. Ratios are a useful way of expressing these relationships. Ratios express one quantity in relation to another (usually as a percentage or times).
The universe of ratios is limitless as are no authoritative bodies specifying exact formulas for computing ratios or providing a standard, comprehensive list of ratios. Formulas and even names of ratios often differ from analyst to analyst or from database to database.
Financial ratios provide insights into:
- Relationships within a company that help analysts’ earnings and free cash flow.
- Company's financial flexibility to obtain the cash required to meet its obligations, even if unexpected circumstances develop.
- Management's efficiency in carrying out the work.
However these ratios also suffer from certain limitations, summed up below:
- Study of companies in the same industry: Only the companies within a specific industry can be compared as the nature of industry changes form one another and so does the dynamics.
- Ratios carry no meaning when seen in isolation; they must be compared with other companies’ ratio or last year performance to make some meaning out of it.
- Use of alternative accounting methods: This may result in different figures of certain items which may lead to distortion of ratios and as a result give wrong indications. Most notable examples being inventory valuation (LIFO, FIFO) and depreciation method used (straight line or declining balance).
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