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Analysis of financial statements has being part of the bed rock of finance itself. For publicly traded companies, the greater level of participation by the general publics and sometimes global stakeholders has meant comprehensive assessments are done on their financial statements. Some of the basic reasons for the assessment of the financial statement of companies include the evaluation of current operations, compare the current performance with past performance, make comparison against other firms and industry standards, study the effectiveness and efficiency of operations and the level of efficiency in the utilization of resources.
The rationale behind the assessment of a firm's financial statement is such that a firm has being given resources; it is supposed to convert those resources into profit through the production of goods and the provision of services. Accounting ratios are meant to measure the relationships between resources and financial flows to show ways in which the firm's results deviate or otherwise from its own past, that of competitors and ultimately the industry as a whole.
Broadly, ratios are classified into three categories namely financial ratios, operational ratios and valuation ratios. Financial ratios cover liquidity and leverage ratios, operational ratios deal with activity and profitability ratios while valuation ratios assess market prices relative to assets or earnings. Each one of these classes of ratios measures various components of the company's overall performance and provide insight to investors and other interested parties alike. The very popular ratio used in the general assessment of a company's performance has being the Return on Investment (ROI), which is itself one of the profitability ratios.
A performance measure used to evaluate the efficiency of anÂ investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the result is expressed as a percentage or a ratio.
The return on investment formula:
In the above formula "gains from investment", refers to the proceedsÂ obtained from selling the investment of interest.Â Â Return on investmentÂ is a very popular metric because of its versatilityÂ and simplicity. That is, if anÂ investment does not haveÂ a positive ROI, or if there are other opportunities with a higher ROI, then the investment should be not be undertaken. It is important to state that there could be a modification on the calculation on the Return on Investment to accommodate various situations - basically it boils down to what you include as returns and what you include as cost.
The uses of the ROI and other financial ratios/measures in assessing the performance of a company have numerous benefits that accrue to both the users as well as the organization itself. The main benefit of using Return on Investment (ROI) and the reason for its popularity is the simplicity of its calculation. ROI estimates the return of an investment by looking at the benefits and costs associated with the investment.
ROI is particularly easy to calculate and understand when compared to other financial tools such as Net Present Value (NPV), Internal Rate of Return (IRR), and Payback Period. Although the calculations for these financial tools are more complex, the results are arguably more accurate. Nonetheless, ROI is an appropriate first step for estimating the economic return of an investment. Other ROI benefits include the use of the tool to establish an initial framework of assumptions to ultimately determine the value of the project.
The ROI calculation forces a thorough thinking of investment variables such as intangibles, risk, and timing. These assumptions are as important as the ROI calculation itself because they are the inputs that will ultimately impact the overall ROI result
Ratios help in the assessment of the profitability of a business concern through the various profitability ratios, which serve as a guide to analysts in assessing the earning capability of the company and its management. With the help of solvency ratios, solvency of the company can be measured. These ratios show the relationship between the liabilities and assets. In case external liabilities are more than that of the assets of the company, it shows the unsound position of the business.
In this case the business has to make it possible to repay its loans. Ratio analysis help the outsiders just like creditors, shareholders, debenture-holders, bankers to know about the profitability and ability of the company to pay them interest and dividend etc. Accounting ratios indicate the trend of the business. The trend is useful for estimating future. With the help of previous years' ratios, estimates for future can be made. In this way these ratios provide the basis for preparing budgets and also determine future line of action.
Accounting ratios attempt to highlight relationships between significant items in the accounts of a firm. By calculating ratios, we can assess the profitability, efficiency, and solvency of the firms yet they are inconclusive and hence have their own limitations in their functions and therefore cannot be used as the sole means of assessing the performance of publicly traded companies. Some of the limitations of the ROI are discussed below.
The ROI calculation does not take into account the time value of money or the risk associated with a project or investment. The time value of money concept says that a dollar earned today is worth more than a dollar earned tomorrow. This is particularly true when considering other investment alternatives and the effect of inflation from a macroeconomic perspective.
In addition, the risk of the project needs to be accounted by incorporating all the possible financial outcomes associated with the project. These possible outcomes include the possibilities that the project will not yield the expected results because of the inherent risks of the project. The fact that risk and the time value of money are omitted in the ROI calculation may cause managers to mistakenly reject projects that otherwise should have been approved.
This is particularly the case if projects with different risk profiles were compared using the ROI methodology. The ROI value of the project with the higher risk should be reduced to account for the broader range of outcomes when compared with a project with lower risk. ROI calculations may over-value investments since the equation favors short-term savings and overlooks long-term costs such as maintenance, support, and software upgrades. This problem is the result of using a one-year time span in the standard ROI calculation to determine the value of the project. Therefore, projects having large costs in the future may incorrectly appear to give a higher return because the future costs are not included in the calculation.
The fact that ROI can be calculated several different ways creates a problem of consistency. Few companies have developed a single ROI methodology, thus making it difficult to accurately compare and evaluate the economic return of several projects. This problem is accentuated when comparing the value of software from multiple vendors, each of whom may have used a different methodology to arrive at the ROI for their particular software. Managers selecting a software vendor have the task of untangling the true ROI from each vendor, and creating a normalized, single view for comparison purposes.
Generally, aside the ROI, other measures of performance companies also have their inherent limitations and could therefore be inadequate in highlighting the stated performance. Usually, It is difficult to generalize about whether a particular ratio is 'good' or 'bad'. For example a high current ratio may indicate a strong liquidity position, which is good or excessive cash which is bad. Similarly Non current assets turnover ratio may denote either a firm that uses its assets efficiently or one that is under capitalized and cannot afford to buy enough assets.
Secondly, through creative accounting some accounts of the company are adjusted therefore, ratio analysis can give false explanations to the users. The limitations in information problems are also there because ratios are not definitive measures, outdated information is presented in the financial statements, historical costs is not good for decision making, and ratios give general interpretations.
Another category of limitation is "Comparison of performance over time". These limitations are caused by ratio analysis because of price changes, technology changes, changes in accounting policy and impact of trading size. The choices of accounting policies may distort inter company comparisons. Example IAS 16 allows valuation of assets to be based on either revalued amount or at depreciated historical cost.
The business may opt not to revalue its asset because by doing so the depreciation charge is going to be high and will result in lower profit. Moreover, Ratios are based on financial statements which are summaries of the accounting records. Through the summarization some important information may be left out which could have been of relevance to the users of accounts. The ratios are based on the summarized year end information which may not be a true reflection of the overall year's performance of the organization under consideration.
As evident from the foregoing, it is obvious that though the ROI and other measures of financial performance of organizations are important, their limitations make them inadequate in making objective conclusions on the performance of these organizations in question.
It has therefore become necessary for other option to be considered with the hope of painting a better picture of organizations' performance. Recently studies about company performance measurement system not only focus on financial measurements but also non-financial measurements. There are both quantitative and qualitative methods presented to measure organization performance. Many researches have shown that conventional financially based performance measurement systems have failed to measure and integrate all the factors critical to success of a business. To deal with the new environment, new performance measurement systems have been proposed such as the Balance Score Card.
The balanced scorecard (BSC) is a strategic planning and management system that has wide applications in both manufacturing and service industries. The main goals of BSC are to align business activities to the vision and strategy of the organization, improve internal and external communications, and monitor organization performance against strategic goals. This approach generally split strategic measures into one of the following: outcome or driver measures, financial or non-financial measures, and internal or external measures. Using these different types of measures, the scorecard measures organizational performance in terms of four balanced perspectives: financial, customers, internal business process, and learning and growth.
With respect to customer perspective, recent management philosophy has shown an increasing realization of the importance of customer focus and customer satisfaction in any business. Poor performance from this perspective is thus a leading indicator of future decline, even though the current financial picture may look good. In developing metrics for satisfaction, customers should be analyzed in terms of kinds of customers and the kinds of processes for which we are providing a product or service to those customer groups.
The learning and growth includes employee training and corporate cultural attitudes related to both individual and corporate self-improvement. In the current climate of rapid technological change, it is becoming necessary for knowledge workers to be in a continuous learning mode. Metrics can be put into place to guide managers in focusing training funds where they can help the most.
Looking at internal business perspective metrics allow the managers to know how well their business is running, and whether its products and services conform to customer requirements (the mission). These metrics have to be carefully designed by those who know these processes most intimately; with our unique missions these are not something that can be developed by outside consultants. Finally, the financial perspective asserts that timely and accurate funding data will always be a priority, and managers will do whatever necessary to provide it. With the implementation of a corporate database, more of the processing can be centralized and automated and thus there will be less focus on financial assessment that leads to 'unbalanced' situations with regards to other perspectives.
Through the use of ratings, periodic performance scores can be calculated for organization and these scores help organizations to qualify their outcomes more accurately. Besides, the approach easily allows organizations to calculate their performance in future periods and compare it with previous ones making it more adequate than the overdependence on ROI and its related financial measures.