Using financial ratios to view a company’s health is a useful tool used by investors and shareholders. Taking information off of the company’s financial reports such as the balance sheet and income statement and comparing key numbers from those forms has been proven to be a good barometer of where the company is going and if the company would be a good investment. It is important to realize however that while financial ratios are helpful they do have some possible shortcomings.
One ratio that many view as important when considering a company’s financial health is called the current ratio. The current ratio is very simply the company’s current assets divided by the company’s current liabilities. This simple ratio should be a good indicator of a company’s short term liquidity, however the effectiveness of this ratio is questioned because “current liabilities are never wholly discharged, and current assets are never entirely available to meet current maturing obligations by analogous reasoning” (Zeller, Stanko & Cleverly, 1997, p. 62-6).
Another failure of using ratios to calculate a company’s health is the complexity of calculating and interpreting the ratios. Overanalyzing the data gained from ratios can cause a company or investors to delay action because there is simply too much data. In one study of ratios it was found that in reality “the majority of the information in the original 28 ratios can be provided by six ratios” (Zeller, Stanko & Cleverly, 1997, p. 62-6).
One of the benefits of using ratios is it can often identify an issue in the company’s financial data and suggest a solution. Years ago Home Depot was experiencing rapid growth and expansion and was suffering problems with cash flow due to the growth. Ratio analysis indicated that the best way from the company to continue growing was to maintain the same sales amount per transaction and increase the number of transactions per store. A marketing plan was devised to increase traffic in existing stores which helped the company (Financial ratio, 2003, p. 1-1).
Another benefit to using financial ratio analysis is that since it is an accepted practice when investors are comparing companies it can create a common ground for comparison. Although there may be differences in markets and regions most financial ratios can be compared across several companies and a basis can be seen.
Financial ratio analysis helps home depot nail growth targets. (2003). IOMA’s Report on Financial Analysis, Planning & Reporting, 03(12), 1-1,11+. Retrieved from http://search.proquest.com/docview/203152343?accountid=32521
Zeller, T. L., Stanko, B. B., & Cleverly, W. O. (1997). A new perspective on hospital financial ratio analysis. Healthcare Financial Management, 51(11), 62-6. Retrieved from http://search.proquest.com/docview/196373520?accountid=32521