Question

Often in strategic planning, managers are tempted to look at financial ratios when determining strengths and weaknesses. However, relying too much on them might be ineffective. Why is this so?

Answer 1

Develop the answer from the following key points:

Financial ratios are those ratios which use the numerical values taken from financial statements- Income statement, Balance Sheet and Cash flow statement, to gain meaningful information about a company. Financial ratio analysis assess company's liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more. Financial Ratios helps to track and make comparative judgement about the company's performance. Ratios can reveal a company's financial strength and weaknesses and thereby provide guidance to managers for future business plans and strategic decision making process. At the same time it will be ineffective if the managers rely too much on financial ratios in strategic planning and decision making. Because,
- Financial ratios do not capture all the important information about the business.
- Financial ratios do not directly reveal the quality and experience of the management team which is a key factor in strategic planning.
- Financial statements are prepared on book value (historical value), which do not reflect the current reality in the business.
- Historical values do not reveal the financial health of the company.
- Financial ratios do not indicate the reason behind the changes in value of numericals shown in financial statements which is also a key determinant in strategic planning.
- Accounting policies followed by each company is different. It will affect the comparison between companies. eg: Inventory value at the end of a period will be different for a company following, FIFO method and another company LIFO method.
- Financial ratios do not give due weightage to general economic conditions, industry situation, position of firms within the industry, mode of operations, size of firm, diversity of product, etc. which are the key aspects in identifying the strength and weaknesses of the company.
- Financial ratios consider the position of a business on a particular date only.
Therefore, financial ratios can only be considered as one of the tool for strategic planning and decision making.