C3 Merits of Shareholder Ratios
Merits
Compare to previous periods
Compare to other firms
Compare with other investments
Drawbacks
historical data
time lags
ignores external factors
inconsistent
Merits of Shareholder Ratios
Ratios can be used to compare the performance of a company to previous accounting periods. By generating figures that are easy to compare, managers can make assessments on whether performance is improving or declining. This allows them to analyse strategies that are working and identify areas where there are issues that need to be addressed.
Ratios can be used to compare firms to others in the same industry. Organisations within the same industry will be of various sizes so comparing raw data does not indicate performance. Generating ratios allows firms to make comparisons based on specific areas of performance.
Ratios can be used to compare the share ownership of a firm with alternative investment opportunities. Potential investors will be interested in comparing the potential return on different investment opportunities. By comparing performance rather than raw financial data, investors can make better predictions on which investment will give them a better return.
Drawbacks of Shareholder Ratios
Ratio analysis is performed using historical data. Future performance may not follow trends from the past. Decisions based on an assumed trend such as lending money to a firm with historically good liquidity may result in defaulted payment.
There are time lags between the release of financial statements. By the time financial ratios are being performed, values may be inaccurate as a result of factors such as inflation. This would be lead to decisions made on the basis of ratios being informed by inaccurate financial data.
Ratios only analyse quantitative data and ignore external factors so do not provide a full picture of current and future company performance. External factors such as competitor actions, the economy and climate can all change the performance of a company. It is therefore essential to only use ratio analysis as part of a decision-making process with consideration of a range of external factors.
There is no consistent basis for comparison. Different firms may produce their financial statements in different formats. This makes it difficult to compare different organisations with complete confidence.
There is always a degree of risk in investment opportunities. Ratio analysis can support a decision to invest or not to invest through informing estimations. However, there is never certainty in what will happen in the future.
Non-financial factors should also be considered when measuring the performance of a firm. This may include the human element. The level of morale and skill in a workforce may be a more important indicator of success for some stakeholders. Financial ratios would not communicate to stakeholders which company had a better impact on communities and the environment.