Advantages & Disadvantages of using Ratios in Financial Analysis
In recent years, financial ratios are becoming increasingly important for investors and capital providers seeking information about the financial position and performance of enterprises (Malikova & Brabec, 2012). This section discusses the advantages and disadvantages of using ratios in financial analysis.
One of the advantages of using ratios in financial analysis is that they provide investors with the capacity to effectively “compare the contemporary financial position and performance of selected companies and try to forecast their future development” (Malikova & Brabec, 2012 p. 150). As such, the capital providers are able to make feasible investment decisions using ratios such as return on equity (ROE) and net profit margin (NPM). The second advantage is that ratios provide internal users (management and employees) and external users (shareholders, creditors, suppliers, customers, and governments) with quality information for the decision-making process. For example, ratios such as current ratio and quick ratio provide short-term creditors with quality information on a company’s capacity to pay the short-term debt without regard to the liquidity of current assets, or without having to rely on the sale of inventory (Zager et al., 2012).
Among the disadvantages, it is evident that ratios are affected by different accounting standards and hence may end up exhibiting differing information depending on the accounting standard used to prepare the financial statements (Malikova & Brabec, 2012). Investors may end up getting inaccurate information about the financial health of a company depending on, for example, different requirements of disclosure and presentation of financial statements. A second disadvantage is that ratios are more concerned with explicating relationships between past financial information (historical information) of a company’s performance while investors and creditors are more concerned about the current and future performance of the firm (Alireza et al., 2012).
The Profitability, Liquidity, Efficiency & Stability of Business
The business selected is Rose Chong Costumes, and the ratios considered include asset turnover ratio and debt ratio. The firm is undoubtedly one of the largest costume specialists in Melbourne, though it has diversified its services to include theaters, beauty schools, and retail shops (Rose Chong Costumiers, 2012).
The asset turnover ratio “examines how effectively the assets of the company are being used to generate sales revenues” (Malikova & Brabec, 2012 p. 152). In this light, the management of Rose Chong Costumes can use this ratio to assess how the firm’s total assets (theaters, beauty schools, retail shops, beauty parlors, etc) are being employed to generate the sales of the firm. To improve this ratio, the management must always endeavor to achieve a higher asset turnover, hence must use the available assets more productively to achieve competitiveness and higher performance due to the increase in sales revenues.
The debt ratio “represents the first and broadest test of indebtedness of the company so that it expresses the relation between the total debt, both current and long-term, and total equity and liabilities of the company” (Malikova & Brabec, 2012 p. 152). Consequently, the management can use this ratio to assess the indebtedness of the company in relation to its total equity. To improve this ratio, the management of Rose Chong Costumes must ensure the ratio remains low by minimizing the level of liabilities. This way, the company will be able to attract creditors and minimize the potential risks for the owners of the firm. A high debt ratio is not good for a business since it constrains a firm’s capacity to attract both short-term and long-term lenders.
Alireza, F., Parviz, M., & Mina, S. (2012). Evaluation of the financial ratio capability to predict the financial crisis of companies. IUP Journal of Behavioral Finance, 18(2), 57-69.
Malikova, O., & Brabec, Z. (2012). The influence of a different accounting system on informative value of selected financial ratios. Technological & Economic Development of Economy, 18(1), 149-163.
Rose Chong Costumiers. (2012). Web.
Zager, K., Sacer, I.M., & Decman, N. (2012). Financial ratios as an evaluation instrument of business quality in small and medium-sized enterprises. International Journal of Management Cases, 14(4), 373-385.