3.) uses & limitations of ratio analysis

8/7/2019 3.) Uses & Limitations of Ratio Analysis

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inancial statement analysis involves comparing the firm's. -performance with that of other firms in the same industry and

evaluating trends in the firm's financial position over time, Thesestudies help management identify deficiencies and then take actions toimprove performance ~

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011e of the ways in which financial statements can be put to work isthrough ratio analysis. Ratios are simply one number divided by another;as such the)' "mayor not be meaningful ..In finance, ratios are usually twofinancial statement items that may be related to one another and nlayprovide the prudent user a good deal of .inforrnation. "Financial analysis isas much an art as it is a science. Combine any two figures from an annualreport and a ratio is produced; the real skill is in deciding which figures touse, where to find them and how tQ judge tile result.

.Generally ratios are divided into four areas of classification that providedifferent kinds of information: liquidity, turnover/profitability and debt...., Liquidity ratios indicate the firm's ability to meet it maturing short-

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Turnover indicates how effectively the firrn rnanages resources at itsdisposal to generate sales,Profitability indicates the efficiency with which Ina11ages reS01JfCeS,0

Debt indicates the extent to \;Vhi ell the firm ~sfinanced by debt~Effective ratio analysis involves relating the financial numbers to the

underlying business factors in as much detail as possible. While ratio. analysis may not gjve all the answers to an analyst regardiIlg the firm Sperformance, it will hcl p the analyst frame questions for further probing.In ratio analysis, the analyst can

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Compare ratios for the firm and-other firms in the industry Compare ratios to some absolute benchmark.

Users of 'Ratio Analysis., .Ratio analysis is used by the various groups of people. such as managers,

credit analysts, stock analysts,. business analysts, shareholders, lenders/customers, competitors, etc",

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Managers, who employ ratios to help analyze/ control, andthus improve their firms' operations ..Management and otheremployees are usually most interested in the profit beinggenerated from their section of the businessand in assessingtheir employment prospects' Senior executives are expected.to focus on the overall levels of profitability being providedby the cornpanv's main operating uruts, its strategic businessunits (SBUs)o Their interest should be focused on the future

-potential rather than .the historic performance of thecompany.Credit analysts, including bank loan officers and bond ratinganalysts, who analyze ratios to help ascertain a company'sability to pay its debts; andStock analysts, WI10 are interested in a company's efficiency,risk, and grovvth prospects.Business . analysts may be expected by their clients oremployers to provide an indication of whether a particularcompany's shares are worth holding or buying for future

.gain, or are best SOld immediately. 111ey will study the

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'" Uses and Limitations o r I{atlo Ai ialvsis_,8\.rerages~ Therefore, ratio analysis is more useful for small, narrowly

Lfocused firms than for large, multidivisional ones.Different Accounting Policies ,

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1'11e choices of accounting policies nlay distort inter-companycornpar isons .. For example, accounting standards allows valuation, ofassets to be based on eitherrevalued amount or at depreciated historicalco st. 1 'I1 1ebu siness may opt not to revalue it s asset because by doing so thedepreciation charge is going to be high and 1-viII result in .Iower profitCreative Accounting tT11e businesses apply creative accounting in trying to show the better

... . ~.. "_ ... ~ ~ . _financial performance or position which can be misleading to the users offinancial accounting. For example, accounting standards; require that if an

. . .~:3_asset is revalued and there is a revaluation deficit; it has to be charged asan expense in income statement, but if it results in revaluation surplus the. surplus should be credited to revaluation reserve. So in order to improveon its profitability level the company may select in D its revaluation.programme to revalue only those assets which will result in revaluationsurplus leaving those with revaluation deficits still at depreciated

(Ihistorical cost"

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,Window Dressing_These are techniques applied by an entity in order to show a strong

financial position. Firms can employ window dressing techniques to maketheir financial .statements look stronger. Window dressing techniques are

rtechniques employed .by firms to make their financial statements look4better than they really are.

To illustrate, a Mumbai-based builder borrowed on a two-year basis onMarch 29),2001, held the proceeds of the loan as cash for a few days; andthen paid off the loan ahead of time on April 2, 20010 This improved hiscurrent and quick ratios, and made his year-end 2001 balance sheet lookgood. However; the improvement was strictly window dressing; ~ weeklater the balance sheet was back at the old level.Ratios are not Definitive Measures .Ratios need to be interpreted carefully. They can provide clues to thecompany's performance or financial situation, But on their own, they.cannot show whether performance is good or bad" Ratios require S0111equantitative information for an informed analysis to be made.

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-Uses and Limitations of Ratio Analvsis

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Outda.ted Information in Financial Statement1'11e figures iri a set of accounts are likely to lie at least several months outof date, and so l11igllt not gi\Je a proper indication of the compan}~'scurrent financial position.Financial Statements Contain Summarised InformationRatios are based on financial statements which are strrnrnaries of theaccounting records. Through the summarisation some importantinformation may be left out which could have been of relevance to theusers of accounts" TI1e ratios are based on the surnrriarised year endinforrna tion vVhich n1ay not be a true reflection of the overall year's

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The financial accounting conceptual framework recommends businessesto use historical cost of accoun ting. VV11ere histcncal cost convention isused, asset valuations in the balance- sheet could be misleadillg .. Ratiosbased on this information will not be very useful for decision making,

...Infla tion rna)' have badly distorted firms' balance sheets w recorded valuesare often substantially different from 11true" values. 'Further, since

~ ~inflation affects both depreciation charges and inventory costs, profits arealso affected.. Thus; a ratio analysis for one firm over tirne,or acomparative analysis of firms of different ages, must be interpreted withjudgmentComparison of Performance O~verTimePRICE CHANGES .,

!PChanges in the price levels renders comparisons of results over timemisleading as financial figures will not be within the same levels ofpurchasing power. Changes ill results over time may show as if theenterprise has improved its performance and position when in fact afteradjusting for inflationary changes it will show the different picturecTECHNOLOGY CHANGESWIlen comparing perfo~mance over time, there is need to consider thechanges in technology ..The movement in performance should be in line~ ., with the changes in technology. For ratios to be more meaningful theenterprise should compare its results with another of the same level oftechnology ~s this will be a goo! basis rneasurementof efficiency.

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Uses and Limitations of Rallo j\nalvsis~. . . . .. . . . . .. . _ _ - . . - - -r m m I ......--.--................. _____.........----............ ------...-...........~--..-......,...~ ......._._".,~-.............- +-- -----, "'-~ ~............_-----------~ ...................... . -. -. .. &. ._ - .. __ .. .. .. ._ _ -- .. .. . .. .. .. .. .. .._ ................__ .. _ __ .........................-.....,:.+~~ -+-1 _CHANGES IN ACCOUNTING POLICYt=llallges in aC CO llr1tin g' policy may affect the corn pa rison of resultsbetween different aCC()L111ting years as misleadirlg< 1-11eproblem with this..situation is that the directors, rna)l be able to manipulate the resultsthrough the changes in accounting policy. 111isw()'uld be done to avoid

Lthe effects of an old accountiI1g policy or gain the effects of a new one. It islikely to be done in a sensitive period, perhaps when the business's profitsare low.SEASONAL FACTORS

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As stated above, the financial statements are based on year end resultswhich niay not be true reflection of results year round: Businesses whichare affected by seasons can choose the best time to produce financialstatements so as to show better results. For example, a tobacco growing.company will be able to. show good results if accounts are produced in theselling seaSOI1. This time the business will have good inventory levels,receivables and bank balances will be at its highestoSeasonal factors can also distort a ratio analysis. For example, theinventory turnover ratio for a food processor will be radically different ifthe balance sheet figure used for inventory is the one just before versusjust after the close of the canning season. This problem can be minimizedby llsing monthly averages for inven.tory (and receivables) whencalculating turnover ratios ..'DIFFERENCES IN ACCOUNTING PRACl'ICES

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Different accounting practices can distort cornparisons. As noted earlier,inventory valuation and depreciation methods can affect financialstatements and thus distort comparisons an10ng firms. Also, if one firmleases a substantial arriourit of its productive equipment, then its assetsll1ay appear low relative to sales because leased assets often do not appearon the balance sheet. At the same time. the liability associated with thelease obliga tion may not be Sh01V11 as a debt. Therefore, leasing canartificially improve both the turnover and the debt ratios. However, theaccounting profession has taken steps to reduce this problem.Difficult to InterpretIt is difficult to generalize about whether a particular ratio is "good" or"bad." For example, a l1igh current ratio may indicate a strong liquidityposition, which is good, or excessive cash, which is bad (because excess.cash in the bank is a nonearning asset). Similarly, a high fixed assets

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several different products r the overall bottom Iine will be less affected by adrop in the demand for aI1)T one product.3 BARGAINING POWER OF SUPPLIERSTo what extent does the cOmpan)T rely on a single supplier? Dependingon a single supplier may lead to unanticipated shortages and thus tolower profi ts. - 4 DEPENDENCE or~FOREIGN MARKETS

. .What percentage of the cornpanys business is generated overseas?Companies with a large percentage of overseas business are often able to

"realize higher gro\vtl1 and larger profit margins. However; firms withlarge overseas operations also find that the value of their operationsdepends in large part on the value of the local currency" Thus, fluctuationsin currency markets create additional risks for firms with large overseasoperations. In addition, the political stability of the region is important.5 COMPETITIONGenerally, increased competition lowers prices and profit margins. Inforecasting future performance, it is important to assess both the likelyactions of the current competition and the likelihood of new competitorsin the future.6 FUTURE PROSPECTSDoes the company invest heavily in research and development? If so, itsfuture prospects may depend critically on the success of new products inthe pipeline. For exam ple, the market's assessment of a computercOll1pany depends on how next year's products are shaping up. Likewise,

- , ,investors in pharmaceutical companies are interested in knowing whetherthe company has developed any potential blockbuster drugs that aredoing well in the required tests,7 LEGAL AND REGULATORY ENVIRONMENTChanges in laws and regulations have important implications for manyindustries. For example, when forecasting the future of tobaccocompanies, it is crucial to factor in the effects of proposed regulations andpending or likely lawsuits. Likewise, when assessing banks,telecommunications firms, and electric utilities, analysts need to forecastboth the extent to which these industries will be regulated in the yearsahead, and the ability of individual firms to respond to changes inregulation~

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3.) uses & limitations of ratio analysis

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