During the analysis of an entity’s financial statements different ratios are used such as liquidity ratios, activity ratios, profitability ratios, leverage ratios and market ratios. Liquidity ratios are used to show the organization’s ability to meet its short term obligations while leverage ratios indicate about the companies’ long term solvency situation. Profitability ratios give a picture about the growth and profit making capabilities of the company. All these ratios have their own importance and their limitations. Which ratio is best depends upon the intended use and the underlying decision of the user of the financial statement.
(Internet Center for Management and Business Administration Inc) For being successful in determining which entity is best to invest in results of entity’s financial statements are analyzed by investors, preferably using market ratios. There are many investment ratios which help a financier decide that such as profit earnings ratios. It is commonly used to determine whether the cost of investment is worthwhile by comparing it with earnings. Earnings per share are most widely used ratio and are a good indicator towards showing consistency in company’s growth.
So for shareholders looking for growth in a company will definitely be eyeing on this ratio. Return on equity, on the other hand, shows how well a company is performing with respect to making profits, managing its assets and leveraging. Dividend payout ratio is another imperative ratio for those looking forward to dividend incomes as a source of income; higher the ratio indicating more maturity of a company. Net asset value, return on investments, profit margin, turnover ratio, leverage ratio and dividend yield are some other investment ratios which can also be used depending on the need on the need of the investor.
(Winters A, 2002) However care needs to be taken when interpreting ratio as they too have their limitations. For starters, neither can decision can be arrived at nor any conclusion drawn on the basis of any one ratio. Many of the ratios are used together to form a conclusion and to appropriately draw a complete picture of the affairs of the organization. Most of these ratios use period ends or yearend amounts for calculation though averages should be used to overcome any kind of seasonal effect which misstate the answers of the ratios. Another limitation is the use of accounting principles.
This is because dissimilar principles result in diverse amounts hence when comparing ratios with another company, accounting principles needs to be altered in order to bring figures which can be compared fairly. (Internet Center for Management and Business Administration Inc) References Internet Center for Management and Business Administration, Inc. Financial Ratios. Retrieved April 30, 2010, from http://www. netmba. com/finance/financial/ratios/ Winters. A. 2002. Investment Tips: What are key investment ratios? Retrieved April 30, 2010, from http://www. essortment. com/career/keyinvestmentr_sape. htm
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