Why Financial Ratios Are So Important to Our Understanding of Health, or of a Firms Financial Results - Essay Example

Financial Ratio Analysis Author’s Name Institutional Affiliation Date of submission Why financial ratios are so important to our understanding of health, or otherwise, of a firm’s financial results; At some point, a reasonable business person or a firm would require to have an in-depth look at their businesses financial health. For instance, when a business is undertaking an expansion project or when the economic situation is such that there is a jump in expenses, the business management would want to know the ability of the business to finance such a project or expenses or even its ability to service loans or credit if the management opts to go that way. Investors and financiers on the other hand have a lot of interest in the financial health of a business to gauge whether the business is able to meet its financial obligations while being able to give the desired returns to the shareholders, investors and other relevant stakeholders (Babalola, 2013). As far as gauging a businesses’ financial health is concerned, a ratio analysis on the firm’s financial statements becomes a vital tool. Financial ratio analysis not only gives a picture of the company’s financial health but also how the firm might improve its financial health. The main reason why financial ratios are important to our understanding of health or otherwise of a firm’s financial results is because financial ratio analysis makes a comparison between different aspects of the firm’s performance including how the firm fares when compared to its industry or region pears. Through financial analysis, the firm is able to know whether it has accumulated too much debt or inventory or whether it is collecting its receivables within a reasonable time for instance. As such, financial analysis gives a comprehensive overview of how the different aspects of the business have performed and hence a good indication of the firm’s financial health. By looking at the firm’s financial statements such as the balance sheet, a firm’s stakeholder such as the lender is able to determine the stability and hence the health of the business. This is because the lender is able to compare what the business owns Vis a Vis what it owes in forming a loaning agreement. In this regard, the lender may request the company to keep its equity above certain percentages of their debt or its current assets above certain percentages of its liabilities. While this is just an area of application of financial ratio analysis in gauging the financial health of a business, it is important that businesses regularly perform financial ratio analysis so that they can keep on top of changing trends not just in the company but also in the industry as a whole. Financial ratio analysis is considered important in understanding the firm’s financial health since it helps the management and other business stakeholders as well in understanding how the business is performing in a number of areas including the liquidity of the business, the efficiency of the business, how profitable the business is and the long-term solvency of the business (Elliott, 2015). These are four areas that act as a pointer towards the health of the firm and if the business is not performing well in any of the above areas, then its financial health is doubted as it might be at stake. The areas as well as how financial ratio analysis helps in gauging their health is explained below. Through financial ratio analysis, a firm is able to measure its ability to meet its short term obligations by measuring its liquidity and hence gauging whether it has enough resources to pay all its obligations whenever they fall due. This is done through calculation of such ratios as current and quick ratio. In case the above ratios are getting lower, it means the company’s health as far as liquidity is concerned is wanting. This shows that the firm might have difficulties in meeting its obligations and also be unable to make use of opportunities that might require quick cash. The vice versa may be true and hence depending on whether the calculated ratios are high or low, the firm might take steps that will enhance its health as far as liquidity is concerned. This might include such steps as paying off current liabilities, delaying purchases or going for long-term debts. The firm will also review its credit policies with clients in a way that receivables are corrected on time. Financial health may also be measured through operational efficiency in areas such as cash flow, collection and operations. Financial ratios will help in calculating such ratios as inventory turnover and debtors’ turnover. Once collected, the firm is able to gauge its health as far as operations are concerned by for instance gauging whether stock is sold on time and whether debts are corrected on time. If the ratios show a decline, the firm is able to take remedial measures thus restoring its operational health. An important area of the firm’s health that financial ratio analysis helps in determining is the firm’s profitability. Such ratios include the net profit margin and return on equity among others. By computing such ratios, the firm is able to gauge its financial viability and also whether it is able to give adequate returns to its shareholders while being able to meet its obligations to various stakeholders. The ratios can be compared over time and it they show a decline, then this is an indication that the firm’s financial health is declining (Vintila, 2012). Thus, depending on whether the profitability ratios are desirable or not, the firm will take adequate steps to ensure that it is in good financial health. Just like for liquidity, financial ratios can help the firm gauge its long-term solvency which is an important aspect of its financial health. This is done through such ratios as debt to equity ratio among others. Such ratios help the firm know whether it using a lot of debts to finance its operations to an extent of not being able to meet its obligations. If this happens, the firm’s operations might be hampered. Thus through financial ratio analysis, the firm is able to decide the optimal level of debt that will not increase the threat of liquidation and take over. Through measuring such aspects as liquidity, profitability, efficiency and long-term solvency, it has been shown that the firm is able to make decisions that help in keeping it financially healthy and hence minimizing the risks associated with bad financial health. Financial ratio analysis not only helps the management but also other stakeholders understanding the firm’s financial health and hence in making informed decisions regarding their future relationship with the firm. Thus, financial ratios are so important to our understanding of health, or otherwise, of a firm’s financial results. Why financial ratios are important in our ability to compare the financial performance of multiple firms in the same industry; Apart from internal uses in gauging the financial health of a firm, another importance of financial ratios is that of helping us compare the financial performance of multiple firms in the same industry. This helps the firm know how well it is fairing Vis a Vis other players in the industry. In this regard, comparing the performance of the firm to that of its major competitors or observing how the firm performs when compared to industry averages will help the users of the financial statements to make informed judgements on key areas including the firm’s profitability or even managerial effectiveness (Bill, 2014). This in essence helps us gauge the firm’s financial health when compared to similar firms in the same industry. This will also help the firm establish its strengths and weaknesses as far as its financial performance is concerned in comparison with other players in the industry and hence come up with policies that assure the firm of good financial health. Financial ratios are seen as important in our ability to compare the financial performance of multiple firms in the same industry as they provide a standardized tool for comparing different firms within the same industry. In other words, it only through ratio analysis that we are able to compare different firms regardless of the differences in their sizes since financial ratio analysis puts all firms on a relatively equal playing platform in our eyes when analyzing their financial performances. In other words, financial ratio analysis helps us to gauge the different firms in the same industry on the basis of their performance as opposed to gauging them on the basis of their sizes, sales volumes or their market share. Thus, a small local firm is able to compare its financial performance with that of Google if they are operating in the same industry. It is worth noting that comparing the two firms using their raw financial data would only give us a limited insight. However, ratios go beyond numbers and reveal how good one firm is at making a profit, its efficiency, funding its operations, growing itself through increasing its sales as opposed to through acquiring more and more debts as well as many other factors when we compare it with similar firms operating in its industry (Salmi, 2015). For instance, although using numbers a big company might have more than five hundred times the amount of revenue of a small firm in the same industry, hence making the bigger company seem very strong when raw numbers are compared. This might not be the case when we compare the two companies using financial ratios such as profitability ratios such as return on assets and return on equity as well as their net profit margin. These ratios might actually reveal that the smaller company is operating more efficiently and hence more profitably as it has been generating more profit per every dollar of asset employed when the financial ratios are compared. Using financial ratio analysis, we are able to reveal trends in the industry in which the firm operates and hence create benchmarks against which the performance of the firms in the industry is to be measured. With the performance benchmarks, firms regardless of their size are able to craft organizational strategy while measuring their own performance against that of other firms in the industry. Thus, if say a debt to equity ratio of a certain firm is 0.85 compared to the industry benchmark of 1.4, then the management of the firm could conclude that the firm is less leveraged than other firms in the industry despite the fact that its total debt may be larger than that of other players in the industry. It can thus be concluded that financial ratio analysis is important in comparing a firm’s performance with that of other firms in the industry as it enables them to be compared at the same level regardless of their size differences and hence the management is able to make informed decisions arising from the comparison. References: Babalola, F2013, Financial ratio analysis of firms: A tool for decision making, International Journal of Management Sciences, vol. 1, no. 4, pp. 132-137. Elliott, B2015, Financial accounting and reporting, London, Rutledge. Vintila, G2012, Business failure risk analysis using financial ratios, Social and Behavioral Sciences, vol. 62, no. 3, pp. 728- 732. Bill, T2014, Business accounting, New York, Taylor & Francis. Salmi, T2015, A review of the theoretical and empirical basis of financial ratio analysis, The Finish Journal of Business Economics, vol. 4. No. 94, pp. 426-448. Read More