Foundations of Financial Management

January (Doctors In Business Journal) - Financial ratios refer to relationships obtained from the financial information of a company, which are utilized for comparison purposes (Eagan, 2018). Financial ratios include return on assets (ROA), return on investment (ROI), and debt-to-equity. They are obtained from dividing one account balance with another (Eagan, 2018).  These account balances are obtained from a company's financial statements, such as cash flow statements, balance sheets, statements of changes in owner's equity, and income statements. Moreover, financial ratios form useful tools that help business owners and managers measure their progress according to their predetermined objectives (Eagan, 2018). Additionally, some of the useful purposes of financial ratios include examining financial statements, making a decision, planning as well as forecasting, judging the performance of a company, realizing gaps, and finding solutions and comparative analysis.

When it comes to analyzing financial statements, financial ratios are important tools that help in conducting an effective analysis of a company (Eagan, 2018). Besides, any isolated financial information is not useful for providing useful information for understanding the financial stand of a company. Financial ratios help in comparing different sets of financial information to obtain reasonable information. Moreover, financial ratios play a great role in decision making, planning as well as forecasting. Business leaders and managers can understand the trends using financial ratios that help them develop informed decisions based on historical data. This allows them to plan for future action. On the other hand, financial ratios help determine the performance of a company. This is accomplished by assisting the analyst in assessing the company regarding its management as well as operational efficiencies. Financial ratios are important when it comes to comparative analysis. It forms a significant tool in comparing distinct entities using the same industry to compare different industries (Eagan, 2018). Moreover, financial ratios determine the department or operational gaps and develop correct solutions to fill these gaps.

Purpose and Importance of Financial Analysis

Financial analysis refers to a process of assessing projects, businesses as well as budgets in order to find out their performances as well as suitability (Carlson, 2020).  Financial analysis is typically applied in examining whether a company is stable, solvent or profitable enough for investment purposes. Besides, financial analysis is of different kinds; fundamental analysis and technical analysis. The financial analysis utilizes ratios from financial statements’ information in order to find out the value of a business (Carlson, 2020). Moreover, by employing financial analysis and a review of economic as well as financial situations within the firm, analysts may achieve an inherent value for the security. On the other hand, technical analysis employs technical trends collected from a trading activity like a moving average (MA) (Carlson, 2020). Moreover, technical analysis tends to analyze the statistical trends collected from trading activities like price movement as well as volume.

Financial analysis is vital for solvency, profitability, stability as well as liquidity. According to Carlson (2020) solvency forms one of the most significant objectives of financial analysis. It helps assess the capacity of businesses to pay back their short-term and long-term debts to their creditors. The business’s liquidity is typically reflected within its balance sheet (Carlson, 2020). A financial analysis also aims to evaluate the profitability of a company, whereby profitability is the company's capacity to earn income and sustain its objective in the long and short term. Moreover, the Statement of Comprehensive Income is used to find out the profitability of a firm (Carlson, 2020). Also, the Income statement provides other details pertaining to the income and expenses of a firm. Moreover, a financial analysis usually reports the capacity of a company to sustain positive cash flow. Also, a businesses’ liquidity is found within the company’s balance sheet.  Finally, financial analysis helps to determine the stability of a business. Stability refers to the capacity of a firm to maintain its existence in the long run. Furthermore, the process of evaluating a company's stability includes the application of the balance sheet as well as the income statement (Carlson, 2020). Also, non-financial and financial indicators are vital during this process.

Limitations of Financial Ratio Analysis

Although ratios are significant tools when it comes to the financial analysis of a company, they are accompanied by several limitations. First, a company may make end-year changes to its financial statements in order to refine its ratios. For such cases, the ratios tend to be nothing but window dressing (Corporate Finance Institute, n.d). Secondly, financial ratios usually do not consider changes in price due to factors such as inflation. Moreover, a significant number of financial ratios are typically estimated through historical costs and involve overlooking shift in prices between different periods of time. This may contribute to a wrong financial situation of a firm (Corporate Finance Institute, n.d). Particularly, accounting rations usually do not consider the qualitative aspect of a company, whereby they consider the monetary aspect, that is, the quantitative aspect of the company. Finally, due to the lack of a common definition of ratios, companies may utilize different formulas. For instance, various firms may take into consideration of all current liabilities in calculating the current ratio. However, others firms may assume bank overdrafts from current liabilities (Corporate Finance Institute, n.d).  

The convenience of Financial Ratios to Different Types of Users

Short-term lenders may prefer liquidity ratios which are basically applied in measuring the capacity of a firm to pay its short-term debt obligations. Moreover, liquidity ratios indicate the short-term weaknesses and the financial strength of a firm. Various types of liquidity ratios that short-term lenders may utilize are the current debt ratio, quick test ratio, as well as cash position ratio. Besides, long-term lenders may want to assess the capacity of a company to pay its long-term debts. Therefore, some useful ratios include profitability ratios like return on assets, return on sales, profit margins, and return of equity ratios. On the other hand, shareholders want to deploy financial ratios in order to assess investments that may contribute to sustainable results. Therefore, they may employ different financial ratios to accomplish this; financial ratios like return on sales, return on equity, return on assets; liquidity ratios like quick ratio, current ratio; and price ratios like price to earnings ratio as well as dividend yields.

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Additional credible news sources for further research and citations:

Bloomberg, The Wall Street Journal (WSJ), Financial Times (FT), Reuters, CNBC, The Economist, MarketWatch, Yahoo Finance, Business Insider, Investing.com, ZeroHedge, The Balance, Morningstar, TheStreet, The Motley Fool

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