Research Paper on Ratio and Financial Statement Analysis

Introduction

Ratio and financial statement analysis are tools that users of accounting information apply to gain more understanding and interpret financial information (Gibson, 2013). The objective of ratio and financial statement analysis is to measure profitability, solvency, liquidity, efficiency, among other aspects of performance and financial condition of an entity. These aspects are critical for decisions by users such as the management, both current and potential investors, creditors, suppliers, customers, among other users of financial information. This report highlights the benefits and limitations of financial statement analysis, as well as the factors that affect the meaningfulness of financial ratios.

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Benefits of Ratio and Financial Statement Analysis

Financial statement analysis, including financial ratios, help in analyzing the financial performance and status of an entity (Weygandt, Kimmel & Kieso, 2015). Profitability is one of the performance aspects of interest to investors and management. Profitability ratios help assess the profitability of a company thereby assisting investors and management in their respective decisions. For instance, a low operating margin ratio can imply that the firm's operations are not efficient or it is not generating sufficient revenues. Vertical analysis of the income statement, alongside other ratios, provide valuable insights to help management identify problem areas (Weygandt, Kimmel & Kieso, 2015). If the company's operating margin is low and the vertical analysis indicates that the operating expenses constitute a significant percentage of total revenues, then the problem could be inefficient operations. The management can correct this by initiating measures to reduce operating costs or increase revenues. Investors also look at profitability measures such as net profit margin and return on equity. Investors buy stocks with higher profitability ratios since they generate a high return on investment.

Ratio analysis also assists users in evaluating the operational efficiency and liquidity of an entity (Gibson, 2013). Operational efficiency regards the management of assets and is of concern to the management. Efficiency ratios include inventory turnover, receivables turnover, and asset turnover, among other ratios. The management relies on this information in decision making. For instance, if the receivable turnover is low, the company can face liquidity problems. The management can introduce measures to improve debt collection such as cash discounts, shortening credit period, among other aggressive collection policies. Liquidity ration analysis facilitates working capital management. The management can use liquidity ratios to determine whether the company has a sufficient working capital or not, and implement measures to ensure daily operations are well funded (Weygandt, Kimmel & Kieso, 2015). Liquidity analysis also helps short-term lenders as well as suppliers. A supplier would be reluctant to offer credit facilities to a firm with low liquidity.

Financial ratio analysis helps in evaluating the financial stability or solvency of a firm (Gibson, 2013). Solvency ratios such as debt ratio, debt-equity and times interest earned ratios, assess the ability of the firm to meet its debts. This analysis influences capital structure decisions by management as well as investors' decisions. For instance, the management of a company can use the leverage ratios to assess the impact of financing decisions on the capital structure thereby influencing financing decisions (Weygandt, Kimmel & Kieso, 2015). The management of a company with a high debt ratio may consider equity financing rather than additional debt. Besides, an investor can rely on leverage ratios to determine whether to invest in a company's bonds or not. Investors consider companies with a high debt ratio as having a higher risk and require higher returns on such investments than on firms with low leverage.

Financial statement analysis also enables users to compare the performance of a firm between two or more periods (Weygandt, Kimmel & Kieso, 2015). The changes in financial ratios between two or more periods indicate whether the firm's performance and financial status are improving or declining. For instance, a fall in net profit margin shows that the profitability of the firm declined and the management can identify the potential causes and take corrective actions. Investors may consider a decline in a company's profitability as a red flag and sell its stock.

Ratios also enable the comparison of a firm's financial performance and condition with that of a competitor or an industry average (Gibson, 2013). Comparing the financial ratios of a firm with that of the industry average or a competitor is beneficial to the management for purposes of benchmarking. The management would be confident that the company is performing well if it outperforms a competitor or industry average. Since financial ratios are relative measures, it is possible to compare firms of different sizes. Investors also rely on comparative analysis when considering investment options. For instance, investors require a higher return on bonds and other debt instruments of companies with high leverage since they involve higher risk than companies with lower leverage. When considering stocks to purchase, an investor would select a share with the highest profit and potential return which is determined using financial ratios.

Limitations of Ratio and Financial Statement Analysis

Financial ratios rely on historical financial statements thus making them unreliable for certain decisions (Gibson, 2013). Companies release their financial statements months after the end of the fiscal periods. Price level changes among other changes affect the value of historical figures. Therefore, ratios do not reflect the current status of the entity of interest. Stock prices can change every second hence relying on past financial statements alone to decide whether to acquire or sell a stock can be misleading.

Analysis of financial statements ignores qualitative factors that might be essential for investment and other decisions (Weygandt, Kimmel & Kieso, 2015). Qualitative factors such as level of competition, managerial competence, laws and regulations, industry growth rate, among others are essential factors that are not included in financial ratios. For instance, a company implementing a stock repurchase program has high leverage. It could be misleading if an analyst focuses on the high ratio and concludes that the firm is not financially stable without considering the qualitative information regarding the program.

There is no standard benchmark for determining whether a ratio is good or bad (Gibson, 2013). This makes the interpretation of financial ratios difficult and subjective. For instance, a current ratio that is greater than one is usually considered good as it indicates strong liquidity. However, a low current ratio is not necessarily bad. It may imply that the firm is efficient in generating cash as well as using its working capital. In some industries, a low current ratio is more favorable than a high current ratio. High leverage is associated with a significant financial risk, but it is not always bad. The company may be increasing its leverage to improve the return on shareholders' equity.

Comparative analysis using ratios can be misleading due to the differences between firms (Weygandt, Kimmel & Kieso, 2015). Even firms in the same industry may have different operating structures, among other aspects. Besides, accounting standards give entities the leeway to adopt different accounting policies such as depreciation methods, valuation of inventories, among other accounting policies. Comparison of ratios of companies that use different accounting policies can result in misleading results. For instance, a company valuing inventory using LIFO understates its current year's net income. Thus, comparing its performance with one that uses FIFO may show that it is less profitable although that may not be the case. Therefore, an analyst must review the accounting policies of firms being compared and determine if the differences have any significant impact on the financial ratios. Besides, comparing ratios with an industry average can be deceptive. According to Constable and Armitage (2006), batting averages used for industry performance are not always reliable. The industry average may be too low or too high. When it is too low, an investor may accept an investment that does not a sufficient return. On the other hand, if the industry average is high, there is a risk of rejecting an otherwise profitable stock.

Factors Impacting the Meaningfulness of Financial Ratios

Variables affecting the usefulness of financial ratios include timeliness, audit quality and link to qualitative information. Financial information is useful only if it is timely. Historical financial statements may not reflect the current and future status of the firm (Weygandt, Kimmel & Kieso, 2015). Thus, investors rely on recent quarter financial information instead of the annual figures that may be outdated. Financial ratios are also useful if they are properly audited. Auditing enhances the credibility of accounting information by providing an independent opinion on whether it fairly represents the true and fair view of the firm's financial status. In some cases, executives manipulate financial statements to mislead investors and other users. Financial ratios based on misstated financial statements can lead to unsound investment and other decisions.

Financial ratios can only be meaningful if they are linked to qualitative information that provides more insights into the firm's future performance. A user must consider qualitative information to explain financial ratios. For instance, if there is an increase in net profit margin, analysts should determine the reasons behind the improvement. In the fiscal year 2017, most US firms saw an increase in net income due to the effect of Tax Cuts and Jobs Act. The Act led to substantial one-time tax benefits for most firms. Even firms that experienced a decline in revenues and operating income had their net incomes increase due to the Act. Qualitative information such as strategic initiatives is more reliable for estimating future performance than historical quantitative measures.

Emerging Practices or Theories in the Application of Ratio and Financial Statement Analysis

Analysts are now considering additional financial measures to assess the financial stability of a company. According to Khalil (2010, p.46), traditional solvency ratios financial ratios are not sufficient for identifying financial distress (bankruptcy). Audit quality and other dynamic ratios provide relevant information about a firm's financial health. (Khalil, 2010, p. 46). When evaluating a firm's financial health, it is essential to consider other measures besides the traditional solvency ratios.

While financial statements present historical information, the annual reports contain disclosures on forward-looking financial statements. Ratio and financial statement analysis can be more useful if analysts consider forward-looking statements and the respective disclosers. Forward-looking statements are reliable in predicting the future performance of a company (Athanasakou & Hussainey, 2014). Athanasakou and Hussainey (2014), forward-looking disclosures enhance the credibility of earnings reported in financial statements. Forward-looking information is critical in critical in determining a borrower's probability of default (Jureviciene & Raulickis, 2016). Market analysts give forward-looking ratios such as EPS, earnings growth rate, P/E ratio, among other measures.

Analysts...