What Are the Advantages & Disadvantages of a Financial Ratio Analysis of a Firm?

What Are the Advantages & Disadvantages of a Financial Ratio Analysis of a Firm?
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When valuating a company, different values are needed to get an accurate picture. Most of the values come in the form of ratios, a form of financial comparison. Financial ratio analysis is the combination of several of these formulas that help paint a picture of a company's overall financial health and stability. The ratios are used for several reasons, from determining whether a company is a good investment to whether it is a candidate for merger or acquisition.

Ratio Analysis Definition

As an owner of a business, it pays to know what the business is worth and how its value compares to other businesses in the same industry. It's also just good business sense. You can only know how well a business is performing and where its deficits lie by knowing how well the business is functioning. Financial ratios can help with that determination.

Types of Ratios

There are dozens, if not more, ratios that can be used to measure some aspect of a company's performance. However, for a general overall evaluation, financial leverage ratios, profitability ratios and cash ratios can likely paint an adequate picture. If those ratios are positive, then you or your investors can delve deeper into the more specific ratios.

Financial Leverage Ratios

These ratios measure business equity by examining its debt. They are also referred to as equity and debt ratios.

The equity ratio is computed by dividing the total equity of the business by its total assets. A higher equity ratio is preferred because the higher the ratio, the less debt a business typically has.

The debt ratio measures a company's total debt as a percentage of its total assets. In other words, this ratio shows how many assets a business would have to sell to pay off all its debt. The debt ratio is computed by dividing total liabilities by total assets. In this instance, the lower the ratio, the better.

Profitability Ratios

These ratios are used to show how profitable a business is. The more profitable, the more attractive the business is to potential investors. They also show how well a company uses current assets to generate profits, and how easily a business could liquidate some of its assets to pay off liabilities.

  • The profit margin ratio compares the net income and the net sales of a company. Using this comparison, it can be determined how well sales generate net income. This is computed by dividing net income by net sales.
  • The gross margin ratio is computed by dividing gross margin by net sales. This ratio indicates how well a business converts its merchandise into sales.
  • The return on equity ratio shows how well a business converts investments into profits. This ratio is of special interest to investors because it gives an indication as to whether or not their investment is being used to its maximum potential.

Cash Ratios

These ratios show whether a business can pay off its debts with liquid assets. Investors like to see that a business can handle its debt, so this ratio is important. It is computed by adding cash and cash equivalents together and dividing that amount by the total current liabilities.

The higher the ratio, the better a business can handle paying off its debt quickly. A ratio under 1 means a business needs more than its cash reserves to pay off debt.

Advantages and Disadvantages of Ratio Analysis

One of the advantages of financial measures is that the ratios can be used to paint a positive picture of a business. If the ratios fall in line with what is acceptable to investors, getting additional funding could be a breeze.

On the other hand, ratios still only show certain aspects of a business. Even if some of a business' ratios are upside down, the business could still be thriving and solvent. Ratios are ultimately snapshots of a business on any given day. To get a real idea of how successful a business is, these measures should be looked at over a period of time.

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