Financial ratios are important indicators of the fiscal condition of an organization. Companies in various industries are unlikely to have similar ratios as their productivity, profitability, use of assets, and inventory turnover, among other factors may differ. This post will discuss financial ratios, how they may differ across different industries, and their uses and limitations. Specifically, the ratios will be illustrated by applying the examples of Amazon and Bentley Motors Limited.
There are five categories of financial ratios, with each of them having several sub-categories. The main categories are liquidity, activity, leverage, performance, and valuation. Liquidity is the capability to repay short-term debts, whereas leverage ratio is concerned with long-term obligations (Leeds, 2020). Activity, including inventory turnover, is the measure of productivity (Leeds, 2020). Performance assesses the ability to generate profit, while valuation demonstrates stock market value (Leeds, 2020). Overall, these ratios illustrate how successful a company is and whether it can generate revenue and pay off its short-term and long-term obligations.
It is generally accepted that the financial ratios in different industries will vary significantly. It can be assumed that the liquidity of Amazon is higher than that of Bentley. As a vehicle manufacturer, Bentley invests more into its inventory while producing a limited range of luxury products. Meanwhile, Amazon requires some inventory, but the sales of its products and services are much higher. Similarly, the activity ratio, specifically total asset turnover, is substantially higher for Amazon as they provide a greater variety of differently priced goods. Thus, it can be argued that the activity and liquidity of a retail company are higher than that of a vehicle manufacturer.
Financial ratios have both benefits and limitations to their implementation. They are easy to use and can provide necessary information on performance over time. This data can be used to identify whether any changes are needed in the company’s organizational structure or its business model. In addition, they are useful for comparing the productivity of different companies in the same industry. Ratios can be impacted by inflation, failing to illustrate performance correctly (Corporate Finance Institute, 2020). Significant alterations to the structure of the company and operational changes can also influence the accuracy of the financial ratios. Furthermore, all information presented in ratios is historical and may fail to illustrate the current financial standing of the business. Finally, the ratios are easy to manipulate to demonstrate a healthier financial situation to potential investors.
References
Corporate Finance Institute. (2020). What is Ratio Analysis? Web.
Leeds, P. (2020). Five financial ratios for stock market analysis. The Balance. Web.