Question

1. How do you think financial ratios differ across different industries? Compare two industries of your choice and select a few ratios and explain whether you think the ratios would be higher or lower for each of those industries and explain why. 2. What are some uses and limitations of financial ratios?

Answer 1

(1).

It is true that financial ratios differ across different industries because main objective of different industry is different so when main objective is not same of all types of industry then financial information of all types of industries will be different. We know that financial ratios are calculated on the basis of financial information that is why financial ratios will be different for different types of industries.

Now let’s study some financial ratios for two different types of industry;

For Bank & Financial industry;

Follosing financial information are given;

Cash……………………..$15000

Short-term investment…..$25000

Other current assets…….$10000

Current liabilities……..$20000

Fixed assets…………..$25000

Net profit……………….$10000

Now let’s calculate some financial ratios;

Current ratio = Current assets / Current liabilities

Curreny ratio = $50000 / $20000

= 2.5 times

Return on total assets = Net profit / Total assets

($10000 / $75000) * 100 = 13.33%

Return on fixed assets = Net profit / Fixed assets

($10000 / $25000) * 100 = 40 %

Return on current assets = Net profit / Current assets

($10000 / $50000) * 100 = 20 %

For Manufacturing industry;

Follosing financial information are given;

Cash……………………..$12000

Short-term investment…..$5000

Other current assets…….$2000

Current liabilities……..$20000

Long-term loans………$18000

Fixed assets…………..$45000

Net profit……………….$17000

Now let’s calculate some financial ratios;

Current ratio = Current assets / Current liabilities

Curreny ratio = $19000 / $20000

= 0.95 times

Return on total assets = Net profit / Total assets

($17000 / $65000) * 100 = 26.15%

Return on fixed assets = Net profit / Fixed assets

($17000 / $45000) * 100 = 37.78 %

Return on current assets = Net profit / Current assets

($17000 / $20000) * 100 = 85 %

So on the basis of above ratios of two different industry it is clear that financial ratios showing different results. Currrent ratio of bank shows high ratio because a bank has to maintain high liquidity whereas manufacturing industry operates on credit that is why current ratio of manufacturing industry is low. Apart from this we know that a manufacturing industry has to maintain high level of fixed assets in compare to banks that is why return on fixed assets, return on current assets will be different for both type of industry.

Thus it is clear that due to different types of financial composition of financial data of different industry financial ratios will show different picture.

(2).

Use of financial ratios;

Following are the main uses of financial ratios;

1. Financial ratios help in anlyzing performance of industry during a time period of time.

2. Financial ratios help in comparative study because it provide to the point financial information.

3. Financial ratios help in financial decision making because due to availability of summerised information quick decisions can be taken.

4. Financial ratios helps in finding out weak and strength areas in the industry.

5. Financial ratios helps in better controlling.

6. Financial ratios help in providing precise financial information to the various stakeholders.

7. It helps in study of past performance of a particular firm or overall study of the industry.

8. It helps in setting normal standards for the firm and industry.

7. Financial ratios helps in future correct planning etc.

Limitations of financial ratios;

Following are the main limitations of financial ratios;

1. Financial ratios are calculated on the basis of historical financial information that is why these ratios can not provide up to date information.

2. Impact of inflation can not be measured in the ratios analysis.

3. Every firm and every industry uses different policies that is why these financial ratios can not provide comparable information.

4. As we know that financial ratios are based on past accounting information that is why future planning can not be made accurately.

5. Sometime manipulated financial ratios can lead to inaccurate standards for the industry etc.