Ratio Analysis: Some Pros & Cons

Pros and Cons Of Financial Ratios

Pros and Cons Of Financial Ratios

It is often very difficult to gauge the organizational performance from one or two simple numbers. Nevertheless, several different ratios are usually calculated in strategic planning to provide useful information about the organization's financial position.

Financial ratios are used to assess the company's performance relative to specific business operations. They can also be used to review financial performance from separate business divisions or departments.

Pros Easy to use Most of the businesses use financial ratios because of their simplicity. Organizations typically prepare a month-end financial statement for review by business managers. Financial ratios do not require any additional information beyond the financial statements. Spreadsheet and other accounting software's can be used to implement ratios into the business operations without much effort. The software helps generate these ratios automatically once the financial statements are completed.

Provides Benchmarks Financial ratios often provide benchmark for small businesses. Many business owners use benchmarks to compare their company's financial and operational performance with another company or the industry. This comparison helps the businesses to focus on specific operational improvements. Also, business owners can create historical record relating to financial ratio benchmarks.

Cons

Myopic Review Process Even though ratios provide business owners with useful information, they also have a few disadvantages. Firstly, such ratios provide business owners with a myopic review of their company's performance. Financial statements indicate a dollar value relating to business operations. Even if the financial ratios present a positive picture of the business in comparison to the industry standard, internal business operations may be struggling.

Businesses must focus on eliminating waste and escalating production output from current operations. This performance review process does not generally require financial ratios.

Potentially Worthless Financial ratios alone do not provide business owners with much value. These ratios usually need a comparison number so the business can gauge the effectiveness of their operations. Small business owners may struggle to find another business with similar operations for comparison in this process. The industry standard for financial ratios can also distort the business's financial ratio information. Large organizations are generally able to run operations more efficiently than smaller businesses.

A minimum of five years worth of ratios need to be analyzed to get a clear picture of the company's financial position. Even when the good and bad aspects of how a company has performed overtime have been revealed, the investor's job isn't finished. This information needs to be analyzed in light of the economy in general and other companies of similar size and type or in other words the competition.

Source http://www.researchomatic.com/Financial-Ratios-41160.html