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The Benefits and Limitations of Ratio Analysis (Coursework Sample)


for this assignment, i was required to provide a discussion on the use of ratio analysis in determining the suitability of investing with a given company.


The Benefits and Limitations of Ratio Analysis
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Executive Summary
Ratio analysis is a fundamental process of conducting comparison for accounting information. The key benefit of ratio analysis rests with the fact that it allows for immediate comparison of performances on both an internal and external basis. Users of accounting information rely on ratio analysis to make informed decisions about the future of a company. For instance, management of a company will need to calculate these ratios in order to ascertain future plans of the activities of the firm as a whole.
However, the uses of ratio analysis can be limited in cases where financial statements, which are the main source of data, are exposed to elements of manipulation and personal bias. Other than that, ratio analysis has been in used, for a substantial number of years, to determine whether businesses deserves credit or are worth to invest in by potential investors.
The Benefits and Limitations of Ratio Analysis
Financial ratio analysis is a continuous process used in the course of determining and providing relevant interpretations of relationships created between specific items of financial instruments. This, in turn, aids with the provision of meaningful understanding for the performances and positions of firms. It should be understood that the fundamental objective of financial ratios rests with the determination of earning capacities and also, the financial soundness of organizations (Halabi, Barrett and Dyt, 2010).
The use of financial ratios, to determine the financial position and soundness of particular entities, has been used for a substantial number of years in the real world. The analysis of financial statements, using ratios, by real world companies involves the comparison of a firm's exact performance with that of other entities operating within the same industry. This, in turn, helps management to identify possible deficiencies and thus, take reasonable steps to improve on the underlying performance (Halabi, Barrett and Dyt, 2010).
The Benefits of Financial Ratios in Real-Life Scenarios
First, ratio analysis is used in the course of evaluating the financial statements of a given company. This is highly attributed to such users of accounting information as bankers, creditors and potential investors to a firm. Such ratios as profitability, debt and liquidity ratios have, for a long period, used by users of financial ratios to make informed decisions in respect to the respective interests with companies (Harris and Washington, 2013).
Second, ratio analysis has been used for a substantial number of years to simplify accounting figures that would otherwise remain challenging to interpret. Users of ratio analysis information vary depending with their respective interests with a given firm and thus, they would need information that is summarized and set in a systematic manner. This is easily facilitated by the deployment of ratio analysis technique. It has been ascertained that while making informed decisions on whether to engage with any given entity, at whatever level possible, it is important to determine whether their accounting figures are simplified to the least possible degree (Harris and Washington, 2013).
Third, ratio analysis, in real life scenarios, has been used extensively to perform informed judgment in regards to the efficiency of business operations. It should be understood that different accounting ratios have continued to be used for evaluating the exact financial health of a given entity. On a more specific perspective note, the process involves analyzing solvency and liquidity ratios of a given firm (Harris and Washington, 2013). Retrospectively, the results of the aforementioned analysis aids management with accessing distinctive financial regulations in respect to the various business units existing within the organization as a whole. For instance, Motorola Company might use the ratio analysis information to determine the respective performances of each of its business units and thus, placed in a fair position to plan for the future.
Fourth, the accounting information derived from ration analysis processes is considered to be useful in respect to forecasting. Businesses, around the globe, are known to use ratio analysis in making future plans so that a distinctive course of action is assumed in a near future on the rationale of trend of the ratios (Harris and Washington, 2013). For instance, the accounting department of a company such as Motorola Company might embark on calculating a trend of profitability, solvency and liquidity ratios for a number of years in order to determine the immediate course of action that will be assumed in the near future in respect to activities like expansion projects and soliciting for additional funds.
Fifth, information derived from the process of ratio analysis is considered to be useful in the determination of exact weak spots of an organization, in its entirety. It should be understood that the process concerned with the calculation of ratios is specific in nature. This means that, although the overall deduction of an analysis might be depicted as having portrayed a good position, with the ratios in place, weak spots are recognized (Zager, Sacer, and Decman, 2012).
For this matter, the management of such an organization as Motorola Company might embark on paying much attention to such a scenario and thus, assume remedial actions. For instance, in a case where the company finds out that there was an immense increase in the level of distribution expense in comparison to the end results attained, then, an effective remedial approach can be taken in order to eliminate possible wastage of resources.
Sixth, ratio analysis has been, for a substantial period of years, used as an accounting tool for making distinctive inter-firm and intra-firm comparisons. It should be ascertained that firms like Motorola Company will at all times embark on making comparisons of their respective performances with that of their immediate competitors within the industry. This is considered an inter-firm comparison (Zager, Sacer, and Decman, 2012). For instance, given that Motorola Company operates within the telecommunication industry, it might embark on using its ratio in respect to the performance of such a competitor as Nokia or Apple Inc. subsequently, the comparison can be narrowed down to the different units but of the same organization. This type of comparison is intra-firm in nature.
For that case, it can be decided that information derived from the process of ratio analysis is used as a distinctive tool to postulate the different performances of the business units existing within an organization and also, between the firm's year-to-year performances with that of the competitors. This enables management of the organizations to come up with innovative ideas on matters related to the future plans of all activities.
Possible Limitations in the Use of Ratio Analysis Information
First, the process of conducting effective and efficient ratio analysis largely depends on the degree of financial statement representations. This means that financial statements are the immediate raw data for making ratio analysis. Thus, in the case that these financial statements are incorrect, it will also mean that the ratios calculated are incorrect. In the recent past, some of the leading companies have been depicted as having manipulated their financial statements in an effort of attracting potential investors or soliciting for funds. For this case, these organizations will thereby conduct ratio analysis using incorrect data in order to come up with desired results (Zager, Sacer, and Decman, 2012).
Second, the use of ratio analysis information becomes complicated to the immediate end-user especially because different interpretations are impacted on different terms altogether. For instance, a company like Motorola might embark on calculating some of the ratios with their respective profits after tax and interest while others, which operate within the same industry, might opt to use profits before imposition of interest and taxes (Harris and Washington, 2013). This then becomes a challe...
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