Limitations Of Ratio Analysis

Importance of Ratio Analysis in Financial Analysis

On comparing the ratios calculated in 2015 and 2016 following points can be stated.

Gross Profit Margin – This ratio helps in showing how much profit the company is making in comparison to the total sales of the company.The higher the gross profit ratio, the better it is. It reflects the overall policies of the company which comes from cost of goods sold and other credit giving facilities that the company have(Alsagoff, 2010). In the given case of the company in comparing both the given years 2016 and 2015 we see that in 2016 the ratio was 14.63% and in 2015 the ratio was 16.55%, so this an adverse condition and the company needs to see why there is a detoriation in the ratios from the prior years and how it can be improved.

Return on Total Assets – The ROA shows the overall return on the assets of the company by comparing the net profit of the company with the total assets. The higher the ratio the better it is as it shows that the company is earning enough profit in comparison to the total money that it has invested in its assets. Thus it can be said that the company is making good use of all its assets for generating effective revenue for the company. In comparing the given years 2016 and 2015, it can be seen that in 2015 the ratio was 8.44% and in 2016 the ratio is 0.87 %, so that is a darastic fall and it shows that the company is not functioning to the best of its abilities as the net profit is less in comparison to the amount of assets the company is having. From 2015 to 2016, there has been a lot of fall in the ROA and thus this shows that the financial health of the company is not in the best condition and in case the company wants to do better they need to analyse the reasons for such discripancies and make effective use of the assets(Kusolpalalert, 2018).

ROE/ Net Profit to the Equity – This ratio shows the overall return on the equity of the company by comparing it with the net profit of the company. This is one of the most important profitability ratios for the investors as it helps them to understand whether the company is paying good returns on the equity investment to the shareholders of the company. A high ROE is better as it reflects a better financial position and which means that the company is making better returns and thus this puts the shareholders in a good position. On comparing the ROE of 2015 and 2016, we see that in 2016 the ration was 4.4 % and in 2015 the ratio was 18.67 %, thus we see that there was a detoriation from the prior year, and thus there should be an analysis to check why this situation has occurred and how the same can be reversed(Coate & Mitschow, 2017). The investors will not put their money in the company is the ROE is so less and keeps reducing over the years, that’s why we see how ratios are a good way to analyse the overall financial position of the company.

Profitability Ratios and Their Implications

Current Ratios = Current Assets/ Current Liabilities. It helps in finding the balance between the current assets and current liabilities of the company and whether the company is having enough assets to pay off its liabilities. It helps in ascertaining the overall liquidity position of the company and helps in judging whether the company is making correct decisions or not with regards to its overall investments in current assets and this is turn helps in making conclusions regarding the financial position of the company. It is said the higher the ratio the better it is, as it predicts that the company is having adequate assests and the liquidity position is stable. In the given case we see that in 2016 the current ratio was 1.46 whereas in 2015 the current ratio was 2.33, thus we see that there is a detoriation from the prior years and the company needs to change its financial management policies and needs better management of the working capital of the company.

Return to Shareholders Investment – Shareholders are the people who are putting their money in the company and therefore it is very important that they get enough returns else they will not put their money. The higher the ratio the better it is and reflects better positions for the shareholders in terms of money management and investment . In this case we see that in 2016, 0.044 and in 2015 it was 0.186, so there is a degradation from the prior years which also reflects the fact that the company needs to make changes in its overall financial policies and should take help of experts to make sure that they are managing their operations in such a way that enough revenue and return is generated (Gullet, Kilgore, & Geddie, 2018).

Operating Profit Margin – Operating expenses are those that are directly related to the sale of goods and services. Earnings before interest and taxes is basically known as operating profits and it is important that companies should invest their funds in their operations in such a way that the overall operating cost is low so that operating profit is higher. In this case also it is said that higher the profit the better it is. We see that in 2016 the operating profit margin was 0.022, and in 2015 the profit margin was 0.066, so that means in 2015 the operating cost was low in comparison to the total sales and thus profit was relatively higher. The main aim of the company to check the reasons of such changes and work to change this (Johan, 2018).

Gross Profit Margin

On Comparison the industry’s ratio to the entity ratios following points are noticed.

1.In case of gross margin ratio, the industry ratio is 86.1 % in average and of the company in 2016 is 14.63%. A high gross margin ratio reflects higher efficiency of doing the core operations related to the business and making sure that the overall profitability is more (Iggers, 2018). A low gross margin ration reflects the fact that the overall cost of goods sold is more and that is having adverse effect on the profitability of the company. Hence it can be said that the company is not in a good position on comparison to standards of the industry.

1. In case of return on total assets, it reflects how much after-tax profit the company is making in comparison to every single amount of asset that it has. This ratio shows how asset intensive a company is. In the given case the return on assets ratio of the company is 0.87 % and that of the industry is 5.4, which shows that in comparison to the industry the company is less asset intensive which is adverse in nature for the growth of the company.

3.Collection period of the receivable shows in how many days the company can rotate its receivable based on its receivable turnover ratio. It reflects the overall credit policies of the company and its overall standing in the financial system, a lower ratio is better because it reflects that the credit policies of the management of the company is good enough and there is no delay in collection of cash. In the given case the collection period of the industry is 14 days and that of the company is 32 days, thus this shows that the company is in an adverse position (Wellmer, 2018).

1. Net profit to equity or ROE is a very important profitability ratio and helps in calculating how much profit the company is earning in comparison to the amount of money the investors have put in. In the given case we see that the ROE of the industry is 16.2 % and that of the company is 4.4%. The higher the ROE the better it is, as it reflects that the investors will have more return on the amount that they are investing in the company, so this means that the company is in an adverse position.

Limitations of Ratio Analysis are-

• In case the accounting datas are not correct then the ratios that are calculated are not corrected, thus there is a lot of dependency on accounting data and financial statements and the accounting policies that are followed by the companies(Shimamoto, 2018). Different companies have different accounting policies and no common platforms based on which they prepare their financial statements  so cross comparison between the companies and their competitors cannot be done.
• Ratio analysis are calculated based on quantitative analysis and does not take into consideration the quantitative factors that might affect the company’s performance also.
• Ratios cannot be considered as a single factor of analysis for the companies’ performance, they provide a fraction of information only and thus it becomes important to understand that they need to be used with other methods in combination for best results(Abdullah & Said, 2017).
• Interpretation of the ratios is also a difficult task if people don’t have enough knowledge regarding that. Thus, it is important that having financial knowledge and knowledge about the ratios is imperative for best results.

References

Abdullah, W., & Said, R. (2017). Religious, Educational Background and Corporate Crime Tolerance by Accounting Professionals. State-of-the-Art Theories and Empirical Evidence, 129-149.

Alsagoff, N. (2010). Microsoft Excel as a tool for digital forensic accounting.

Coate, C., & Mitschow, M. (2017). Luca Pacioli and the Role of Accounting and Business: Early Lessons in Social Responsibility. 

Gullet, N., Kilgore, R., & Geddie, M. (2018). USE OF FINANCIAL RATIOS TO MEASURE THE QUALITY OF EARNINGS. Academy of Accounting and Financial Studies Journal, 22(2).

Iggers, J. (2018). Good News, Bad News: Journalism Ethics And The Public Interest. 

Johan, S. (2018). The Relationship Between Economic Value Added, Market Value Added And Return On Cost Of Capital In Measuring Corporate Performance. Jurnal Manajemen Bisnis dan Kewirausahaan, 3(1).

Kusolpalalert, A. (2018). The relationships of financial assets in financial markets during recovery period and financial crisis. AU Journal of Management, 11(1).

Shimamoto, D. (2018, JANUARY 29). Why Accountants Must Embrace Machine Learning. Retrieved from global-knowledge-gateway: https://www.ifac.org/global-knowledge-gateway/technology/discussion/why-accountants-must-embrace-machine-learning

Wellmer, A. (2018). The Persistence of Modernity: Aesthetics, Ethics and Postmodernism (fourth ed.). UK: Polity Press.

On comparing the ratios calculated in 2015 and 2016 following points can be stated.

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