What is the purpose and importance of financial analysis? What are financial ratios? Describe the “five-question approach” to using financial ratios.  What are the limitations of financial ratio analysis? If we divide users of ratios into short-term lenders, long-term lenders, and stockholders, in which ratios would each group be most interested, and for what reasons?

 

Financial analysis is used to analyse the past performance of a business. It is further used to form opinions about investment value and expectations of future performance. It is also used to ascertain the investment value of a business, stock or any other asset of the business. Financial analysis also helps the users of financial statements to compare the performance of the business with that of its competitors or the industry averages.

 

Financial ratios are comparisons of financial analysis in which specific financial statement items are divided by others to reveal their logical interrelationships. Ratios reflect the relationships between individual values and depict how a company has performed in the past. They also help in forecasting how it might perform in the future.

 

The five question approach to using financial ratios is as follows:

 

Is the firm liquid enough?

How profitable is the business?

How are the assets of the business financed?

Are the managers of the firm creating value for the shareholders?

Is the business able to make efficient use of the resources by generating good returns on the investments of owners?

Limitations of Ratio analysis are as follows:

 

Information used for analysis is historical. The current values may be quite different.

It ignores the effects of inflation.

Changes in accounting policies and estimates may yield very different results and the ratios may become incomparable to past year data.

Ratio analysis ignores business conditions. For instance a drop in profit from 60% to 40% may be perceived negatively if the recession in the economy is ignored.

 

Short-term lenders would be most interested in Current and acid-test ratios to determine the ability to liquidize their assets in order to pay bills on time.

 

Long-term lenders would be interested in Operating and turnover of assets ratios. This will enable them to determine whether the investment will yield results in the long run or not. They are also interested in knowing whether the amount invested by them will be efficiently used or not.

 

Stockholders would be most interested in the EPS and P/E Ratios. This will enable them to determine the amount of dividends that they will receive. The P/E Ratio measures the market price of the share as a proportion of the earnings per share. This enables the shareholders to determine the time that will be required to recover the initial investment. Dividends per share and dividend yield ratios are also useful for the shareholders.