Discuss the purpose and importance of financial ratios and financial analysis. What are the limitations of financial ratio analysis? If we divided the users of financial ratios, such as short-term lenders, long-term lenders, and stockholders, which ratios would each prefer and why? Provide examples.

Financial ratios are measures that are good indicators of firm's performance along several parameters. Typical parameters include assessment of operational efficiency, liquidity, solvency, profitability. These ratios can also be a good early indicators of worsening liquidity issues that may lead to bankruptcy later on. Typically financial ratios are also used to compare a firm's performance over a period of time and also its comparative performance with other firms in the industry. This is a useful tool for investors to measure and compare a company's performance against its peers.

The financial analysis evaluates a firm's financial performance and uses that to predict the future performance. This information is useful for the management to determine future investment decisions.

Some of the limitations of financial ratios include

• Ratios are calculated using the information provided in the financial statements and any incorrect data/manipulation in the statements may lead to incorrect ratios and hence inconsistent decisions
• Since ratios are taken at a point in time, they are likely to be impacted by the seasonality impact in a business
• Ratios do not account for the price changes due to inflation so if the periods under analysis may have had material inflation change, ratio analysis may not depict correct comparison
• Ratios do not account for the qualitative aspects e.g. the ratios of 2 firms may be getting compares whose strategies may be completely different and actually their ratios may actually be a robust comparison
• Calculation of ratios may be impacted by any change in accounting policies followed by different firms and therefore, comparison may not be sensible

Ratio usage

1. Short-term and Long-term lenders - The relevant ratios for the lenders would be Debt Service Coverage ratio, current ratio, quick ratio ,debt-equity ratio. These ratios would help them decipher the firm's debt position and ability clear its liabilities using its assets in the books.
2. Stockholders - Some of the metrics relevant for stockholders would include P/E ratio, return on equity, return on assets, Gross and net profit margin, dividend dividend payout ratio, working capital per $ sales. These ratios will help them determine the financial performance of the business i.e. expected revenue growth, returns on the invested capital and ratios like P/E can also help them determine potential upside scope in the stock price

Reference: Financial Ratios. (2020). Retrieved 26 July 2020, from http://www.netmba.com/finance/financial/ratios/