Ratio Analysis in Finance: Understanding Financial Statements and Performance

FINANCE
Ratio Analysis
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FINANCE
A critical role in the understanding and interpretation of financial statements and related
performance is played by the financial ratios and financial analysis. It is imperative to note that
the financial statements of the company are periodically released so as to provide information to
a wide degree of stakeholders so as to allow them to make prudent decisions with regards to the
engagement with the underlying firm. The financial statements provided by the company need to
be analyzed through the lens of enabling tools such as financial ratios and financial analysis
(Damodaran, 2015). Hence, these tools allow for enhanced understanding of the company’s
performance. Additionally, ratio analysis allows evaluation of key aspects of the company’s
financial performance pertaining to profitability, solvency, efficiency etc. Besides, these
performance aspects can be compared across comparable firms and hence an analysis of the
relative performance of the firm can be drawn. Therefore, it would be appropriate to conclude
that financial analysis and financial ratios enable improved decision making on behalf of a
myriad of stakeholders especially investors (Brealey, Myers & Allen, 2014).
It is noteworthy that despite the wide usage of ratio analysis for analyzing the financial
performance, there are certain limitations of using this tool. One of the key limitations is the fact
that ratio analysis is based on historical performance of the firm since it is derived using
historical financial performance. This historical performance of the firm is not always an
indication of the future performance and hence may lead to incorrect conclusions about the
underlying firm. Also, owing to differential accounting policies, it may not be possible for a
given stakeholder to compare the financial ratios of peer group companies and hence minimizing
the utility of ratio analysis (Brigham & Houston, 2014). Further, the accuracy of financial ratios
is based on the accurate reporting of financial statements and hence, ratio analysis fails in case of
misreporting. The interpretation of the computed ratios is also a challenge considering that both
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