BIshan_BUS621_Week2PA.docx - 1 Financial Ratio Analysis...

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1 Financial Ratio Analysis Bishan Maharjan Westcliff University BUS621: Entrepreneurial Finance Professor Bhatta November 20, 2020
2 Ratio Analysis While financial statements might be a great source of information to learn about the financial position and performance of an organization, it does have its own limitations. To get a detailed insight, analysis of financial statements is conducted to understand the risk and profitability factors associated with any firm. Financial ratios are calculated from the information provided in a company’s financial statements such as income statement, balance sheet, and cash- flow statement[ CITATION Kam04 \l 1033 ]. Financial ratios are categorized into several groups depending upon its relevance to the interest of various audiences. Financial ratios are crucial to govern decisions taken by managers internally, or influence investment decisions to be taken by shareholders and external investors, or auditors to distinguish the financial strengths and weaknesses of an organization. The five boarder types of financial ratios have been briefly discussed below[ CITATION Bea68 \l 1033 ]: Profitability Ratios It used to measure the financial worth and effectiveness of a company’s assets and its approaches towards cost-control to generate profit. Liquidity Ratios Liquidity ratios help an analyst understand the ability of a firm to repay its current liabilities through its current assets (cash and cash-equivalents). Activity Ratios Activity ratios measures the effectiveness of a firm based on how it utilizes its resources, capital, and assets. Debt/Leverage Ratios Debt or leverage ratios study the capability of a firm to repay its long-term debts.
3 Market Ratios Market ratios are quite relevant to shareholders and investors as it analyzes the worth of a company’s stock values. Restrictions of Ratio Analysis While ratio analysis serves a great financial purpose, it does have some restrictions. It allows an organization to compare its current financial performance with its historical performance in the past years, and also allows to compare with similar competitors within the industry. While it may also play a crucial part in governing the future financial decisions, this section aims toward explaining few of the major limitations of using ratio analysis. Use of Historical Data The ratio analysis inputs historical financial data to compute the necessary output. While the information may be accurate, it may not be at all relevant to the current scenario at an organization. The economy at present situation might be facing a recession, but the ratio analysis won’t take that into account which will lead organizations to make ineffective decisions based completely upon the historical data[ CITATION Kad20 \l 1033 ].

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