Question

Answer and discuss this question:

Why is it important for managers to know and understand financial ratios as well as some of the problems with relying on ratios when comparing with other companies?

Answer 1

Why should Managers know and understand ratios and ratio analysis?

Ratio analysis is used to describe relationships between different variables used in financial statements. It is extensively used by finance managers and analysts to make comparison between different companies and between different time periods. Ratios can aid an analyst in judging a company's financial health, projecting earnings & free cash flow and evaluating activity and efficiency.

An analyst can virtually create a ratio by taking any two parameters from the financial statements. So, you will come across various types, names, classification, grouping of ratios. However, finance managers must understand that basic ratios predominately used for analysis remain the same.

Finance managers must know that there broadly there are five sets of ratios which collectively put together can help them judge the financial health of a company. They are:

Sl. No.	Ratio Category	Indications
1.	Liquidity	Indicator of the ability to pay off liabilities in the short term as they come due. Examples: Current ratio, Quick ratio, Cash ratio.
2.	Leverage / Solvency	Indicator of the firm's cost structure (proportion of fixed vs variable costs) financial leverage and ability to meet its longer-term obligations. Examples: Degree of operating leverage, degree of financial leverage, debt-to-equity, debt-to-capital, debt-to-assets, interest coverage, and fixed charge coverage ratios.
3.	Activity / Efficiency	Indicator of how efficiently a company utilizes its various assets. Examples: inventory turnover, receivable turnover, asset turnover etc.
4.	Profitability	Indicator of how well the company generates operating profits and net profits from its sales. Examples: net, gross, and operating profit margins, pretax margin, return on assets, operating return on assets, return on total capital, return on total equity, and return on common equity.
5.	Market / Valuation	Sales per share, earnings per share, and price to cash flow per share are examples of ratios used in comparing the relative valuation of companies.

Some of the problems with relying on ratios

There are certain limitations of ratios arising due to heterogeneity of a company’s operating activities, inconsistency in the results of ratio analysis, judgment required for interpretation and different accounting methods used by different companies.

There are various limitations of ratio analysis:

• Ineffective when used in isolation; should be used in addition to other evaluation techniques.
• Makes sense only for comparison; meaningless unless it can be compared with historical values, peers or industry benchmarks.
• Purely quantitative, doesn’t capture the impact of qualitative factors
• Does not factor in external factors such as macroeconomic conditions, industry cycle, seasonality, change in accounting policy etc.
• Inflation may distort the outcome of financial analysis
• Needs too many adjustments for right comparison if peer set uses different accounting policies or are in different stages of growth
• Thrives on relative analysis, at times finding the appropriate peer set for a company with diversified business portfolio or operations gets very difficult; ratio analysis loses significance in the absence of appropriate peer set.
• Can help identify any outliers but then demand further probe to understand the reason.
• Like to like comparisons should be made so a company which has suffered substantial loss due to exceptional reason cannot be compared directly with the industry benchmark.
• Large companies with diverse business interests are difficult to compare using ratio analysis
• So many ratios have to be calculated, no single ratio can capture all the relevant information an investor need to know about the company.