Friday, July 23, 2010

Limitation of Ratio Analysis

Financial statement analysis is an attempt to work with the reported financial figures in order to assess the entity's financial strengths and weaknesses.

Most analysts tend to favor certain ratios. They may leave out some of those mentioned in this topic and include some not mentioned. Although other ratios may be of interest, depending on one's perspective (i.e., manager, stockbroker, investor, creditor), there is no use in computing ratios of unrelated items such as sales returns to income taxes.

A banker, for example, is concerned with the firm's liquidity position in deciding whether to extend a short-term loan. On the other hand, a long-term creditor has more interest in the entity's earning power and operating efficiency as a basis to pay off the debt at maturity.

Stockholders are interested in the long-run profitability of the firm since that will be the basis for dividends and appreciation in the market price of stock. Management, naturally is interested in all aspects of financial analysis since they are concerned with how the firm looks to both the investment and credit communities.