In spite of its limitations ratio analysis is widely used as a means of evaluating the past performance and predicting the future successes or failures of business organizations
Can't find what you're looking for?
Ask a Question, Get an Answer ASAP
Financial ratios have been used for years to evaluate the overall financial condition of a firm. They have a number of limitations but even then they are universally used by managers and accountants alike to evaluate the financial condition. This is because they take into account all the financial statements of the company like the balance sheet, income statement, cash flow statement and Statement of retained earnings. Thus they show the overall picture of where the firm is standing. They are not exact figures of a company's standing, however, they provide as a good base for the current situation of the firm, on which finance people can build upon by using additional financial formulas.
answered 11 months ago
Add Comment
It is also used to calculate potential abuses and inefficient systems in a company. If company a, b and c all have ratio's within an acceptable range of deviation then company d has items that differ it would raise flags as to the reasons and issues related to the variance from the statistical norm for that industry. While not always associated with fraud or deceit these variances can sometime reflect this can be related to older and perhaps inefficient equipment or processes or perhaps a higher quality product. Since it would be near impossible to process every individual transaction of a large company as an auditor statistical test are instead applied to vouch for the probable accuracy of the numbers and amounts that will be reported on the company's financial statements.
answered 11 months ago
Ratio analysis depends on understanding the components of the ratio and relationship to each other, for example when looking for fraud I first calculate the profit margin for at least 4 years, if it is too constant (less than 1% variation) I worry as no ones cost control is that good. Next I look at stock days, if they are increasing the likelihood of fraud is confirmed. To maintain the margin closing stock is inflated, which in turn extends stock days. A stock count will determine actual stock levels and further confirm fraud. The key is to use an appropriate ratio and to analyse over a long enough period. I consider 4 years to be the absolute minimum. Have a look at Altman's Z score for determining the likelihood of insolvency - it is remarkably accurate and compbines a number of ratios, weights them and also adjusts for manufacturing and non-manufacturing companies. Try Benford's Law - Google Mark Nigrini, the current main exponent of the technique. Ratios are like any tool, only as good as the person using them, you have to use the right one for the job and practice improves your technique.
Ask questions on any topic, get great answers from real people for FREE. Blurtit has hundreds of thousand of members so your sure to get the answer your looking for.
