Uses and Limitations

Name: Uses and Limitations
Author: Glenn Dickerson

Learn the uses and limitations of financial ratios.

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Course: On-Demand

Financial ratios all have their uses, but they also have limitations that you need to be aware of. So let's go over how you can use ratio analysis to determine profitability as well as other uses, and then address limitations involved with historical data, excess data, comparisons, and more. Let's examine how an organization utilizes financial analysis and ratios to do a thorough review of financial performance for a given time period. This analysis allows managers and investors to go beyond the numbers that are presented in the financial statements and make determinations about the past success of a company, as well as guide them in developing ongoing plans for their organization. Profitability ratios are a series of measurements that are used to assess a given business' ability to generate earnings from its general operations. The ratios are typically based on a company's level of revenues, operating expenses, assets that it records on its balance sheet, and any investments by its owners, also known as shareholders' equity. Managers tend to use these ratios by developing trend or industry data that allows them to evaluate their companies over time and against their peers. This way, they make sure that they're tracking the goals that were set by the plans that they drafted. To perform a trend analysis, data must be gathered over time. Searching for positive or negative tendencies, they conclude the analyst into whether or not their company is performing well depending on the trend's direction. When using profitability ratios, it's desirable to have numerical results that are higher when compared to other companies in the same industry. The higher ratios are typically an indication that a company is doing well. Some industries experience seasonality in their business, and these ratios can show that over time. They also allow owners and managers to effectively plan for those seasonal changes in activity. Good managers realize that a company's ability to earn money or profit isn't just measured by the amount of money it has in the bank. The true business analysis comes from calculating the profitability ratios, which allow them to make determinations regarding the financial health of their revenue-generating business activities. We can see how companies use these ratios to determine the direction for their business, by taking a look at Abercrombie & Fitch or A&F. For a period of five years, the retailer earned gross margin percentages in the low to mid 60% range. Meanwhile, its competitors, American Eagle and Aeropostale, consistently earned gross margins below 40%. The solid margins A&F earned were a result of its strong brand recognition amongst teenagers who were willing to pay higher prices for apparel displaying the company's logo as compared to other retailers. But at the end of the fifth year, the teen market declared logos out of style. This change in consumer taste presented a challenge for A&F. The company needed to devise a sales strategy that embraced this new trend towards selling apparel without logos. The financial stakes were high for A&F because every 1% drop in gross margin translated to a 14% drop in net operating income. Because of this, they pivoted their sales strategy to increase their profits, removing their logo from their products.

Beginner Provider : Glenn Dickerson 5 Lessons · 15m in Arabic, German, English, Spanish, French, Portuguese, Chinese

Course Description

These lessons explore the uses of financial ratio analyses to determine profitability. You will learn about how historical data and excess data impose limitations upon ratio analysis. You’ll also learn about how comparisons constrain analysis.

What You'll Learn

Apply financial ratio analysis to determine profitability
Identify other uses of financial ratios beyond profitability
Recognize how historical data can limit financial ratio analysis
Understand how excess data can limit financial ratio analysis
Evaluate how comparisons and comparability constrain ratio analysis

Key Takeaways

Financial ratio analysis can be used to determine profitability.
Financial ratios also serve other uses beyond measuring profitability.
The usefulness of financial ratio analysis can be limited by reliance on historical data.
An excess of data can impose limitations on financial ratio analysis.
Comparability and comparisons can constrain what financial ratio analysis reveals.

Frequently Asked Questions

What does this course cover?

It explores the uses of financial ratio analysis to determine profitability, other uses of financial ratios, and how historical data, excess data, and comparisons impose limitations upon ratio analysis.

What will I learn about the limitations of financial ratio analysis?

You will learn how financial ratio analysis can be limited by historical data, by excess data, and by comparability and comparisons.

What lessons are included in this course?

The lessons are: Uses of Financial Ratio Analysis to Determine Profitability; Other Uses; Potential Limitations: Historical Data; Potential Limitations: Excess Data; and Potential Limitations: Comparability and More.

Does this course address uses of ratios beyond profitability?

Yes. In addition to determining profitability, the course covers other uses of financial ratios.