3.7.2 Role, value & limitations of Financial ratios

What is Ratio analysis?

It involves the comparison of financial data to gain insights into business performance

What questions does Ratio analysis help to answer?

• Why is one business more profitable than another?

• What returns are being earned in investment in a business?

• Is a business able to stay solvent? (ability to pay off debts)

• How effectively is a business using its assets?

What is the importnce of comparison and trends?

Calculating just one ratio is rarely enough if you are to gain useful insights into financial performance of a business 

Effective ratio analysis means you :

• Need to compare with competitors 

• Need to analyse over time (trends) 

Where does information for Ratio analysis come from? 

Financial accounts are the source of info you need for ratio analysis 

Ratios perform diff purposes, what 3 main types are they grouped into?

• Profitability 

• Liquidity 

• Financial effiency 

What are limitations of Ratios?

• One data set is not enough  →  ratio data over a period of time is much better 

• How reliable is the financial data? 

• Ratios are based on past  →  not predictor of future 

• Comparability  →  be careful with comparing ratios, e.g. between diff industries 

Why might the financial data used in ratios not be wholly reliable?

• Financial info involves making subjective judgements 

• Diff businesses have different accounting policies 

• Potential for manipulation of accounting info  (e.g. window-dressing) 

What do financial ratios not measure?

They are concerned with financial data

So they don’t tell you directly about how well a business is performing in areas such as :

• Competitive advantages e.g. brand strength

• Quality

• Ethical and CSR reputation

• Human resource management