Ratios in Analysis of Financial Reports

Running head: FINANCE FOR HR LEADERS
Finance for HR Leaders
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Table of Contents
Introduction................................................................................................................................2
Discussion..................................................................................................................................2
Ratio and its use.....................................................................................................................2
Benefits of using the ratios in analysis of financial reports...................................................3
Key Ratios..............................................................................................................................4
Consequences of over-analyzing using ratio analysis and its Pitfalls....................................4
Conclusion..................................................................................................................................4
References..................................................................................................................................5

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Introduction
Ratios play an essential role in the analysis of the reports of an organization. In
finance, a ratio indicates the company’s performance as a key function and helps the
investors and managers or leaders to analyze their business operations and its sustainability
(Williams & Dobelman, 2017). The report aims to discuss the use and benefits of ratios in the
analysis of financial reports. Further, it discusses the risk and drawbacks related to over-
analyzing ratio analysis. In the end, the report concludes that ratio analysis has several
drawbacks, but ratios in the analysis of reports help an investor to obtain data easily and to
evaluate the company’s performance.
Discussion
Ratio and its use
The ratio is one of the tools in finance to analyze and assess the financial performance of an
organization. The values revealed in the financial reports need to be found in terms of the
investors. The ratio is analyzing financial reports put a better understanding for the
stakeholders about the company's fiscal situation, and allows them for beneficial decision-
making (Osadchy et al., 2018). Some of the Use of ratios in analyzing financial reports is as
follows:
 Ratios help the stakeholders to analyze the company’s performance as well as
facilitate evaluation or comparison amongst two or more different entities.
 Ratio analysis simplifies the data mentioned in the financial reports of the company.
Instead of going through the entire statements, investors can easily get the essential
data from a few ratios.
 The ratio analyzed over a long period can reflect some loopholes in the functioning of
a business. Thus, it is also used to detect a problematic trend in business.

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Benefits of using the ratios in the analysis of financial reports
The analysis of financial reports is a process of understanding the profitability and
risk of the company through an analysis of the financial data. The information mentioned
within the company's income statement, balance sheet, and cash flow statements are used in
calculating ratios that insight on the company’s financial performance as well as address the
potential issues.
The Balance Sheet of a company reveals the net worth of an entity. It gives
summations of the entity’s assets, liabilities as well as shareholder’s equity on a specific date.
The ratio analysis consists of a number of ratios that are used to gauge the company's
efficiency. It gives a simplified view of the company's long-term assets and efficient
management of the receivables in the short-term (Greenwood, Hanson & Stein, 2016). Some
of the common ratios include Current ratio, Asset turnover, and Debt to Asset ratio.
The company's Income Statement provides detail about the entity’s earnings and expenses
incurred (direct, indirect, and capital). The ratio analysis shows the sales revenue of a
company after a certain expense indirect costs and also represents the profitability of the
business (Newcomer, Hatry and Wholey, 2015). Thus, ratio analysis provides transparency in
the operating efficiency of a company by analyzing the Income statement. Key ratios for
analyzing income statements include Gross margin, Interest coverage, Operating margin, Tax
ratio efficiency, and Net margin ratio.
The cash flow statement reflects all cash inflow and outflow during an accounting
period in three different parts that are Operating, Investing, and Financing. A high level of
cash flow shows a healthier status to endure deteriorations in operating performance as well
as the company's well ability to pay dividends. Some of the key ratios for analyzing cash flow

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statements are Price to cash flow ratio, Cash flow coverage ratio, and cash flow to net
income.
Key Ratios
In analyzing the financial statement, financial ratios are classified into the categories of
Liquidity, Solvency, Efficiency, and Profitability. The two key financial ratios chosen here to
analyze the financial statement to create a better understanding about the company are
Liquidity Ratio and Solvency Ratio. These two ratio helps in assessing the company’s
financial performance and its stability so that to take an effective financial decision.
Liquidity ratios reflect the cash availability of an entity and its ability to meet short-
term dues. This ratio shows the available level of assets that can be quickly converted into
cash by the entity to meet its obligations (Ehiedu 2014). It indicates the capacity of the
company to clear its current liabilities as well as the level of cash to manage daily operations.
The acid-test ratio and current ratio are examples of liquidity ratios.
The company’s long-term feasibility can be assessed through the Solvency ratios. It
indicates whether the company is capable of meeting its long-term debts to creditors and
withstand itself. The solvency ratio reflects the financial stability of the business because it
measures the debt of the company compare to its assets and equity (Ibendahl, 2016). Debt to
equity and Debt to asset ratio are examples of Solvency ratios.
Limitations and Consequences of over-analyzing using ratio analysis
Ratio analysis is a frequent using tool for analysis of financial statements as it depicts the
entity's financial parameters at a glance (Ilonka, 2015). However, there are certain limitations
as it ignores the qualitative aspects and measures only the quantitative aspects. This only
shows a comparison of a trend rather than finding the reason behind the figure's fluctuations.

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The pitfalls for the shareholder of ratio analysis is that if the proper care would not be
taken to study such amounts that have cause and effect relationship, then it could be
misleading. The ratio analysis provides historical information and not reflect the future trend,
thereby misguide the shareholders in concern to their money. The owner of a small company
finds Ratio analysis difficult because it diverts the attention of the user with the business data,
as it does not consider the size of the business. It also ignores the resultant bargaining power
and economies of scale enjoyed by the large business (Uechi et al., 2015). Ratio analysis does
not consider the impact of market conditions like a boom or recession period; thereby, it is
another pitfall for banker assessing risk.
Conclusion
Ratio analysis provides a better understanding and comparability to the users for the
data in the financial statement. However, the analysis of financial statements through ratio
analysis has several drawbacks. As it ignores the qualitative aspects and business shows their
better position than the actual that is also called as window dressing. The ratios calculated on
such data can have an incorrect analysis of the business.

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References
Ehiedu, V. C. (2014). The impact of liquidity on profitability of some selected
companies: The financial statement analysis (FSA) approach. Research
Journal of Finance and Accounting, 5(5), 81-90.
Greenwood, R., Hanson, S. G., & Stein, J. C. (2016). The Federal Reserve's Balance
Sheet as a Financial-Stability Tool.
Ibendahl, G. (2016). Using solvency ratios to predict future profitability. Journal of
ASFMRA, 195-201.
Ilonka, D. (2015). Financial ratio analysis-instrument for managing the tradeoff
between liquidity and profitability to guarantee financial stability of
entity. Облік, економіка, менеджмент: наукові нотатки, 83.
Newcomer, K. E., Hatry, H. P., & Wholey, J. S. (2015). Cost-effectiveness and cost-
benefit analysis. Handbook of practical program evaluation, 636.
Osadchy, E. A., Akhmetshin, E. M., Amirova, E. F., Bochkareva, T. N., Gazizyanova,
Y., & Yumashev, A. V. (2018). Financial statements of a company as an
information base for decision-making in a transforming economy.
Uechi, L., Akutsu, T., Stanley, H. E., Marcus, A. J., & Kenett, D. Y. (2015). Sector
dominance ratio analysis of financial markets. Physica A: Statistical
Mechanics and its Applications, 421, 488-509.
Williams, E. E., & Dobelman, J. A. (2017). Financial statement analysis. World
Scientific Book Chapters, 109-169.