Advantages And Disadvantages Of Financial Ratios

Financial ratios are instrumental in the process of understanding financial statements. Without a method to compare financial statements among different firms, these arbitrary numbers are insignificant in setting a benchmark nor able to reflect a company’s financial standing. Specialized financial ratios help analysts interpret the myriad of numbers in financial statements (Parrino, Kidwell, & Bates, 2012). There are five widely accepted types of financial ratios that a firm utilizes to gain a meaningful understanding of a financial statement: short-term liquidity ratios, efficiency ratios, leverage ratios, profitability ratios, and market-value indicators. There are many benefits of employing these ratios, but limitations exist as well. Although

Inventory, for example, may be difficult to sell and can highly impact a firm’s ability to pay on its liabilities. The second type of liquidity ratio is the quick ratio, which is similar to the current ratio, but it takes into account the inconvertibility of inventory. It is important to compare these ratios to industry standards for proper analysis to prevent a skewed understanding of a firm’s performance. A retailer, for instance, Target or Walmart that has a high volume of inventory would have a different benchmark than a company that has essentially no inventory, such as a day care

Typically, the longer a sale goes uncollected, the less likely it will be paid. Collecting on accounts receivable also wastes company resources. The fourth is days’ sales outstanding which take 365 days over accounts receivable turnover to calculate the number of days it will take a firm to collect its receivables. Lastly, asset turnover ratio measures a firm’s ability to use its assets to generate sales by comparing net sales to total assets. Managers utilize efficiency ratios because they can make a relative comparison to the industry