Financial ratios will be available and useful when they are making deliberate comparisons in a proper way. Generally, inter-company comparisons would be taken account at the first place. The nature of inter-company comparisons depends on the stakeholder’s objective when looking at the business. From the point of view of management they are likely to assess general company performance. It is important to make comparison among firms of similar size in the same market and industry. Marks ; Spencer’s for instance, would compare itself with Home Base because of the similar nature of their businesses.
A comparison with Tesco or Safeway would be meaningless because these organizations focus more on food than clothing and home furnishings. A potential shareholder, in the contrast, would probably make comparison across industries for return on net assets because they would be seeking companies in industries with higher return values as a basis for investing. Furthermore, comparison over times could express trends which are also considered closely by stakeholders in performance. Stakeholders are looking into business whether operations are improving or deteriorating.
Figures of balance sheet and profit/loss account collected over four or five years provide a useful basis to ratios’ comparisons and to establish trends. In addition, organizations will set targets for overall performance, and performance of individual parts of the business. These targets will be based on the manager’s assessment of prevailing market conditions and the capability of the organization based on available resources. For example, firms will set themselves a higher target for return on net assets based on a boom in consumer spending that they expect to continue.
Ideally, the assessment of performance would be based on a combination of all comparisons; in this case, financial ratios should judge the performance of business accurately and realistically. The strength of financial ratios is to use accounting figures which provide a relatively objective view of an organization’s performance. However, potential problems still exist. Ratios stem from accounting information in the format of balance sheet and profit/loss account. The information thus might be out of data at least several months later and so might not give a proper indication of the company’s current financial position.
This problem can also be associated with “window dressing” which means techniques are applied by the business in order to show a better financial performance or position that can be misleading to the users of financial accounting. For example, assume a company can borrow 20 Million on 23rd December 2003, holding the proceeds as cash, then pay off the loan ahead of time on 5td January 2004. This can improve the current and quick ratios and make the 2003 balance sheet look good. However the improvement was actually window dressing as a week later the balance sheet is going back to old position.
Furthermore, different accounting policies may distort inter company comparison. For instance, a business may not opt to revalue its assets because by doing this the depreciation charge is going to be high and will drive down the profit level such as using historical cost of accounting. Ratios based on this information will not be very useful for decision making. Meanwhile, ratios derive from financial statements which are summaries of the accounting records, some important information left out is inevitable. Thus, ratio itself may not well reflect the overall year’s result.
In a word, ratios have such limitations which can not be ignored when making comparisons to assess business performance. However, it is not easy to generalise whether a particular ratio is ‘good’ or ‘bad’. Ratios need to be interpreted carefully. They can provide clues to the company’s performance, but on their own, they can not show whether performance is ‘good’ or ‘bad’. They need more further analysis of practice. Sony Company, for example, got a high figure of current ratio. It seems to be inefficient to use cash. Whereas, company safely tided over the finance crisis in 1998 by using enough liquid assets-cash.
To think of the growth of organizations, new businesses will be emphasis more on liquidity rather than profitability because for any new firms, survival is the most important thing. Therefore, average performance is not necessarily good. That depends on different objectives set in the different situations of running business. As the business developed, making more profits might be placed at the centre of management’s efforts. A high profitability ratio can still not represent a good performance. Managers should take account into company’s other areas such as solvency, efficiency, cost control and so on.
For example, if company turnovers increased 3 times during last 3 years, yet the profit margin increased only 2 times. So the company may have cost problems. If management can tackle cost problem well, the company would even get more profits. Thus, ratios alone should not be used to assess performance accurately unless managers can consider various factors within the business. What’s more, comparisons with industry average are difficult when a company operates in more than one industry such as Virgin Company. A failure in one industry will be covered by another good one.
That implies that ratios may not reveal potential problems of the company thus, can not assess performance accurately as well. In addition, no tow companies are the same, even though they may be competing in the same industry or market. Using ratios to compare one company with another would be misleading because businesses may have different financial and business risk even within the same industry. Therefore, organizations themselves may distort figures used by ratios in comparison whatever the inter company comparisons or time comparisons.
Using ratios to analyse performance is inevitably affected by outside environment. For example, inflation will result in comparisons of ratios over time misleading as financial figures will not be within the same levels of purchasing power. Also, changes in technology need to be considered in the process of comparing performance over time. Ratios could be more meaningful when making comparisons with other companies of the same level of technology, or results would not be at the same basis to assess efficiency.
Furthermore, a new launched product may fit into consumers’ taste or not so as to suddenly increase or fall in company’s profits. However, the demand also changes quickly due to the consumers’ change and competitors’ reaction. Thus, ratios can not express trends and assess the performance is good or not. Businesses which are affected by seasons can choose the best time to produce financial accounts for showing a better business performance. For example, a tobacco growing company will be able to show good results if accounts are produced in the selling season.
Nevertheless, in planting seasons the company will have a lot of liabilities through the purchase of farm inputs, low cash balances and even non-profits. Political factors also influence comparisons used by ratios. Suppose that a company is given a special policy on tax whilst another within the same type of business is not, comparing the tow companies may be misleading. Trading performance is affected by booms and recessions in economic circumstance as well and these conditions need to be thought in any analysis.