Importance of Financial Statements Analysis & Limitations of Using Financial Ratios

2.4.1    Importance of Financial Statements Analysis

Financial statement analysis is a type of examination that focuses on the key relationships between financial statements. However, it focuses on the evaluation of the past performance of the business firm in terms of liquidity, profitability, operational efficiency, and growth potentiality. According to (Charles J. Woefel 1998), the purpose of financial statement analysis is to examine past and current financial data so that a company’s performance and financial position can be evaluated and future risks and potential can be estimated. He further emphasizes that FSA can yield valuable information about trends and relationships, the quality of a company’s earnings, and the strengths and weakness of its financial position.

 

2.4.2    Tools for Financial Statement Analysis

Financial statement analysis can be performed by employing a number of methods, tools or techniques. As such, according to (Fareed Siddigui, 2014), an assortment of techniques is employed in analyzing financial statements. These include comparative statements, statements of changes in working capital, common size balance sheets and income statements, trend analysis, and ratio analysis.

2.4.2.1 Comparative Financial Statements

This is an important method of analysis that is used to make a comparison between two financial statements. 

The comparative statement of income statements enables to review of the operational performance and to draw conclusions, whereas the balance sheet, presenting a change in the financial position during the period, shows the effects of operations on the assets and liabilities. 

2.4.2.2 Statement of Changes in Working Capital

The purpose of this study is to obtain information about working capital. The amount of networking capital is determined by deducting the total current liabilities from the total of current assets, the statement of changes in working capital provides information in relation to the working capital of the firm between 2 financial periods.

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2.4.2.3 Common Size Statements

The figures of the financial statement are converted to percentages. However, these are statements that indicate the relationship of different items of a financial statement with some common item by expressing each item as a percentage of the common item. 

Such statements also allow an analyst to compare the operation and financing characteristics of two companies of different sizes in the industry. Thus, common-size statements are useful, both in intra- firm comparisons for the same year or for several years. 

2.4.2.4 Trend Analysis

 

2.4.2.5 Ratio Analysis

Analysis of financial statements with the supports of ratios would guide the management in important decision making, implementation, and control. However, the usefulness of the ratio analysis is not only for the financial manager but also for various who are interested to know the different purposes of financial information. 

As such, the analysis of the bank performance concentrates on the following four (4) types of financial ratios:

  1. Profitability ratio
  2. Liquidity ratio
  3. Risk and solvency ratios, and
  4. Efficiency ratios.

2.4.2.5.1          Profitability Ratio

For the most part, if a profitability ratio is relatively high as compared to the competitors, industry averages, guidelines, or previous year’s same ratios, then it is taken as an indicator of the letter performance of the bank. However, in the banking literature, different scholars in measuring bank performance have been used many profitability ratios (Igbal et al.., 2005).

Importance of Financial Statements Analysis & Limitations of Using Financial Ratios

2.4.2.5.2          Liquidity Ratios

These ratios measure the ability of the firm to meet its short-term obligations, maintain cash position, and collect receivables. In a general, sense, the higher liquidity ratios mean the bank has a larger margin of safety and ability to cover its short-term obligations. Because saving accounts and transaction deposits can be withdrawn at any time, there is a high liquidity risk for both the banks and other depository institutions.

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Loan Deposit Ratio (LDR)

 A bank with Low LDR is considered to have excessive liquidity, potentially lower profits, and hence less risk as compared to the bank with high LDR. However, high LDR indicates that a bank has taken more financial stress by making excessive loans and shows the risk that to meet depositors’ claims bank may have to sell some loans at loss.

 

Loan to Asset Ratio (LAR)

Like LDR, the loan to assets ratio (LAR) is also another important ratio that measures the liquidity condition of the bank. 

 Credit Risk and Solvency Ratios

The extent to which a firm relies on debt financing rather than equity is related to financial leverage. 

The more debt a firm has the higher is the chance that the firm will become unable to fulfill its contractual obligations.

In other words, higher levels of debt can lead to a higher probability of bankruptcy and financial distress. 

If the amount of assets is greater than the amount of all types of liabilities, the bank is considered to be solvent. “Deposits” constitute major liability for any type of bank whether Islamic or conventional. A bank is a solvent when the total value of its asset is greater than its liability.

 

2.4.2.5.3          Efficiency Ratios

 

2.4.2.6 Importance of Using Financial Ratios

These are the importance of using financial ratios;

  1. Simplifies financial statements: Financial statements contain the summary one year’s financial activities, that is, application of ratios as against the financial statements. The interested people can know the information without any difficulty because the entire financial statements are simplified in an easy manner.
  2. Facilitates intra- firm comparison: Analysis and interpretation of a particular firm over a period of a year can be made. And also comparison among different divisions of the organization is made easy with the help of various ratio
  3. Planning and forecasting: Actually ratios are derived from the past financial statement. Ratios give suitable guidance to management for formulating various budget and construct relevant policies and also to prepare the future plan of action etc.
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2.4.2.7 Limitations of Using Financial Ratios

 In the real sense, financial statement suffers a number of limitations. When ratios are derived from the financial statements, they also suffer limitations. As such, ratios have to be interpreted carefully. Some of these limitations about using ratios in financial analysis are as follows (Girmachew, 2010).

  1. Difference in definition: There is no clear cut formula for computing ratios. Each and every company follows a formula for computing different ratios. 
  2. It is not substitute for personal judgment: It is only a beginning and gives limited information for decision making. It is just an aid and cannot replace thinking and personal judgment employed in decision making aspect.
  3. Ratios can be manipulated: There will be a great demand for goods during the festivals season when compared to periods. Suppose this inventory turnover ratio is considered for decision making, the result gets distorted. It is necessary to take the average inventories to present a fair view of business activity.

However, despite certain limitations, ratio analysis continues to be a powerful tool for analysis and interpretation of financial statements.

Source: Realitygh.com

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