Discuss aboutthe the use of accounting ratios and whether it gives the best possible analysis of the financial statements?
Our argument lays on an application of ratio analysis on two the leading companies of UK. Ratio analysis can be known as the simple application of accounting ratios to measure the financial position of companies. However, it fails to compare the ratios of one company to that of another. The exact benchmark to compare ratios of one company to another company can often be different due to its area of operations, different depreciation methods, accounting methods, market factors, and market demands. It could be said that good performance of one company may seem like an unsatisfactory performance for another (Barrow, 2011).
The argument lies in whether ratio analysis is the best analytical method for analysis of financial statements. In the context of the argument, we will evaluate the importance of ratio analysis as well as the disadvantages it pose while comparing the ratio of a company of one industry to that of another. The ratio analysis is done on Royal Dutch Shell, which is multinational Gas and Oil Company, which is originally incorporated in UK and is headquartered in Netherland. The ratio analysis of Royal Dutch Shell is compared to that of BP, which is one of the major gas and Oil Company. British Petroleum or BP is headquartered in London in England. Based on the analysis the argument that whether ratio analysis is a most effective tool, or not can be evaluated (Arnold, 2013).
The first part of the essay focuses on the utility of the ratio analysis. Ratio analysis includes evaluation of the company’s profitability, liquidity, Efficiency, solvency and capital structure. The profitability ratios used here are gross income margin and net income margin. The gross profit margin of Royal Dutch Shell for the year 2014 is $63789000/$421105000 i.e. 15.15% and that of 2013 is $69650000/$451235000 i.e. 15.44%. The gross profit margin of BP for the year 2014 is $41328000/$353568000 i.e. 11.69% and that of 2013 is $46211000/$379136000 i.e. 12.19%. The net profit ratio of Royal Dutch Shell for the year 2014 is $14874000/$421105000 i.e. 3.5% and that of 2013 is $16371000/$451235000 i.e. 3.6%. The net profit margin of BP for the year 2014 is $3780000/$353568000 i.e. 1.1% and that of 2013 is $23451000/$379136000 i.e. 6.1% (Nicola?€s, 2013).
The liquidity position of the companies is measured using current ratio and liquid ratio. The current ratio of Royal Dutch Shell for the year 2014 is $ 99,778,000/$ 86,212,000 i.e. 1.16 and that of 2013 is $103,343,000/$93,258,000 i.e. 1.10. The current ratio of BP for the year 2014 is $ 87,262,000/$ 63,615,000 i.e. 1.37 and that of 2013 is $96,840,000/$72,812,000 i.e. 1.33. The liquid ratio of Royal Dutch Shell for the year 2014 is $ 80077000/$ 86,212,000 i.e. 0.93 and that of 2013 is $73334000/$93,258,000 i.e. 0.79. The liquid ratio of BP for the year 2014 is $ 68889000/$ 63,615,000 i.e. 1.08 and that of 2013 is $67609000/$72,812,000 i.e. 0.93 (Brigham & Houston, 2012).
The efficiency position is measured by evaluating the company’s ability to manage its assets. The asset turnover ratio of Royal Dutch Shell for the year 2014 is $421105000/$353116000 i.e. 1.19, and that of 2013 is $451235000/$357512000 i.e. 1.26. The asset turnover ratio of BP for the year 2014 is $353568000/$284305000 i.e. 1.244, and that of 2013 is $379136000/$305690000 i.e. 1.24.
The solvency position or capital structure of the company is measured using solvency ratios. The debt-equity ratio of Royal Dutch Shell for the year 2014 is $180330000/$ 178154000 i.e. 1.01, and that of 2013 is $176364000/$ 184785000 i.e. 0.95. The debt-equity ratio of BP for the year 2014 is $171663000/$112157000 i.e. 1.53, and that of 2013 is $175283000/$ 129775000 i.e. 1.35 (Bekaert & Hodrick, 2012).
After analysis of the ratios, we are discussing the importance of ratio analysis. The gross profit margin of RDS and BP decreases from 2013 to 2014. However, while computing the net profit margin of RDS, the fall in a net profit margin of RDS from 2013 to 2014 is quite less as compared to that of BP. The current ratio of both the company is increasing from 2013 to 2014. The liquid ratio of RDS is slightly poorer than that of BP. The asset turnover ratio of RDS is falling from 2013 to 2014, whereas the asset turnover ratio of BP is increasing from 2013 to 2014. The D/E ratio of both RDS and BP is increasing from 2013 to 2014 (Kapil, 2011).
The accounting ratios are used to measure the overall financial position. Here, RDS is using the financial ratios to compare its performance with BP. It will help us evaluate the historical financial data of the company and based on the analysis, improvements in specific areas can be made. Financial ratios are really important because by checking the balance sheets of the company it is difficult to understand the creditworthiness of the company. However, by using the solvency ratio the debt position of the companies can be understood.
Using the accounting ratios, the future health of the two companies can be evaluated by the stakeholders. For example, if the solvency position of RDS is better than BP whereas the efficiency position of BP is better than RDS. Then it can be expected that lower debt-equity ratio means better debt control and capital structure. The efficiency position of BP is increasing from 2013 to 2014, and it is better than RDS (Eun & Resnick, 2012)
This part mainly deals with the limitations of ratio analysis. The marginal fall in net profit of BP is quite higher than that of RDS. This is mainly because the although both the company operates in a similar industry and have similar accounting structure, but BP has comparatively lower net profit in 2014 because of its failure to control its operating expenses. The different cost position of the two companies may show the poor image of BP to the investors.
Nevertheless, comparing the liquidity ratio of the two companies it can be observed that BP has been successful in maintaining its liquidity ratios to the ideal position. On the other hand, RDS has been able to meet its short run obligation from effective utilization of its assets.
As in RDS, the company has different inventory valuation method and follows a straight-line depreciation method. Thus, the fall in its total assets is proportionately lower than the decrease in its revenue. Due to which the company has a relatively lower turnover position as compared to BP (Grieve, 2013).
Our argument mainly focuses on the use of accounting ratios and whether it gives the best possible analysis of the financial statements. In this context, we made a brief evaluation of the financial statements of Royal Dutch Shell and British Petroleum using accounting ratios. From the analysis, the importance of ratio analysis is done, and examples are given from the ratio analysis of RDS and BP. Although financial ratios are useful because it will help the shareholders, investors and creditors understand, the companies' financial position but it also has some limitations. The second part of the argument focus on the limitations of the financial ratios. Different accounting policies, accounting methods, industry norms and hidden financial data can limit the ratio analysis. The main argument is whether ratio analysis is the best accounting tools for financial statement analysis. In this relation, applications of some of the ratios are discussed. The counter argument to this analysis is the limitations of ratio analysis. Based on the essay it can be concluded that if ratio analysis is conducted in an unthinking and mechanical manner, it can give wrong results but if used effectively then the ratio analysis gives all the financial information (Madura, 2012).
Arnold, G. (2013). Corporate financial management. Harlow, England: Pearson.
Barrow, C. (2011). Practical financial management. London: Kogan Page.
Bekaert, G., & Hodrick, R. (2012). International financial management. Boston: Pearson.
Brigham, E., & Houston, J. (2012). Fundamentals of financial management. Mason, Ohio: South-Western Cengage Learning.
Brooks, R. (2013). Financial management. Boston: Pearson.
Eun, C., & Resnick, B. (2012). International financial management. New York, NY: McGraw-Hill.
Grieve, I. (2013). Microsoft Dynamics GP 2013 financial management. Birmingham, UK: Packt Pub.
Kapil, S. (2011). Financial management. Noida, India: Pearson.
Madura, J. (2012). International financial management. Mason, OH: South-Western, Cengage Learning.
Nicola?€s, C. (2013). Microsoft Dynamics NAV Financial Management. Birmingham: Packt Publishing.