Ratio and Financial Statement Analysis
This paper examines financial ratio analysis by defining, the three groups of stakeholders that use financial ratios, the five different kinds of ratios used and their applications, the analytical tools used in analysis, and finally financial ratio analysis limitations and benefits.
The paper illustrates that financial ratio analysis is an important tool for firm’s to evaluate their financial health in order to identify areas of weakness so as to institute corrective measures.
While financial ratio analysis does contain limitations that include little theory to guide them as well as the use of accounting data based on historical costs that may not reflect a firm’s true economic conditions, it is an excellent tool
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The DuPont company developed a system in the 1960s that puts together some of the most financial ratios and provides a systematic approach to financial system analysis. (Jiambalvo, 2009). The DuPont system is a diagnostic tool that uses financial ratios to evaluate a firm’s financial health. The process of analysis can be broken down into three steps. First, management assesses the firm’s financial health using the DuPont ratios. Second, when any problems are identified, management corrects them, and thirdly, management monitors the firm’s financial performance over time, looking for differences from ratios established as benchmarks by management (Jiambalvo, 2009). Under the DuPont system, management is responsible for making decisions that maximize the firm’s return on equity as opposed to maximizing the value of stockholder’s shares. The system is primarily designed to be used by management as a diagnostic and corrective tool, but it’s not limited to them only as investors and other stakeholders also use it to diagnose the financial state of a firm. The DuPont system is derived from two equations that link the firm’s return on assets (ROA) and return on equity (ROE). The system identifies three areas where management should focus its efforts in order to maximize the firm’s