Referencing this week’s readings and lecture, what are the limitations of financial ratios? Classify your answer into at least the following categories: liquidity ratios, activity ratios, leverage ratios, and profitability ratios.
After review of financial statements, managers can use basic financial ratio analysis tools to establish trends within the financial results of a company through comparing the result of different periods in the accounting period. Different stakeholders will need various financial ratios in different ways (Dobosz, 2013). Executives and managers, creditors, vendors and suppliers, financial analysts, financial reporters, and competitors all need financial ratios for varying purposes. Despite their usefulness, financial ratios are limited in their purpose by various factors such as structure of a company, inflation, seasonality, and accounting methods. There are various types of financial ratios, namely liquidity ratios, activity ratios, leverage ratios, and profitability ratios, all of which serve different purposes.
Liquidity ratios are critical for companies to measure the quality of current assets. They help determine whether a company is liquid enough to cover up its current liabilities. Liquidity ratios include current ratio, the current cash debt coverage ratio, and acid test ratio. Activity ratios, on the other hand, establish how a company makes use of its resources through comparison of certain activities. They are also known as turnover ratios and help determine a company’s effectiveness in managing its liabilities and assets. Activity ratios include accounts receivable turnover ratio, inventory turnover ratio, total asset turnover ratio, and accounts payable turnover ratio (Dobosz, 2013). Leverage ratios establish the level of debt owed to creditors by a company and whether such a company is in a position to pay its long-term liabilities. The term leverage refers to the extent at which an organization borrows money. Leverage ratios include debt to equity ratio, the debt to capital ratio, the interest coverage ratio, cash flow coverage ratio, and the cash debt coverage ratio. Lastly, the profitability ratios are used by a company to establish whether it is operating at a profitable level and measure the success of the company in the industry. Profitability ratios include price/earnings ratio, cash flow margin, the net profit ratio, the dividend yield ratio, return on equity ratio, and return on asset ratio.
In order for the ratios to be useful to managers and the whole of the company, they have to be compared to other similar companies in the industry. This is the only way the ratios can be useful in helping managers make decisions that boost a company’s success and competitiveness in its scope of operation. Internal reporting, which does not have to meet the GAAP standards, helps managers make sound decisions to improve a company’s performance. Budgets versus actual reports and aging schedules for accounts receivable help us understand how internal reports can be used in making decisions which shape the future of an organization.