limitations of analysis

7/31/2019 Limitations of Analysis

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Limitations of Analysis

Dr. Clive Vlieland-Boddy


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No more ratios, please!


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Limitations of Financial Statement

Analysis

Differences in accounting methods betweencompanies sometimes make comparisons

difficult.

We use the FIFO method tovalue inventory.

We use the LIFO method tovalue inventory.


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Limitations of Financial Statement

Analysis

Analysts should look beyond the ratios.

Economicfactors

Industrytrends

Changes withinthe company

Technologicalchanges

Consumertastes


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Limitations Of Financial Analysis

Horizontal, vertical, and ratio analysis arefrequently used in making significantbusiness decisions.

One should be aware of the limitations ofthese tools and the financial statements.

Business decisions are made in a world ofuncertainty.

No single ratio or one-year figure should berelied upon to provide an assessment of acompanys performance.


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Comparison with industry averages isdifficult if the firm operates many different

divisions.

Average performance is not necessarily

good.

Seasonal factors can distort ratios.

(More)

What are some potential problems andlimitations of financial ratio analysis?


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Problems and Limitations(Continued)

Sometimes it is difficult to tell if a ratiovalue is good or bad.

Often, different ratios give differentsignals, so it is difficult to tell, on balance,whether a company is in a strong or weakfinancial condition.


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Ratio Analysis Limitations

Ratios are presented on a percentagebasis

Relative size is ignored (e.g., both large &

small firms can be compared) It is assumed that all numbers used are

correct (consider both possible errors and

earnings management) If the numbers are not reliable, ratios are

not particularly useful


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Limitations of FinancialAnalysis

Business decisions are made in a world ofuncertainty.

No single ratio or one-year figure shouldbe relied upon to provide an assessmentof a companys performance.


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Limitations of Ratio Analysis

A firms industry category is often difficult to

identify

Published industry averages are only guidelines.

Rarely are two companies exactly the same. Accounting practices differ across firms

Sometimes difficult to interpret deviations in

ratios Industry ratios may not be desirable targets

Seasonality affects ratios


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Analysts should understand the followingaspects when dealing with ratios

A ratio is not "the answer". A ratio is an indicator ofsome aspect of a company's performance in thepast. It does not reveal why things are as they are.Also a single ratio by itself is not likely to be veryuseful.

Differences in accounting policies can distortratios (e.g. inventory valuation, depreciationmethods).

Not all ratios are necessarily relevant to a particular

analysis. Analysts should know the questions forwhich they want to find answers, and know thequestions that particular ratios can help answer.

Ratio analysis does not stop with computation;

Interpretation of the result is vital


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Continued

How homogeneous is the company?

Are the ratios comparable between divisionswithin a company? It is critical to derive

comparable industry ratios. However, manycompanies have multiple lines of business,making it difficult to identify the appropriateindustry to use in comparing companies.

Companies are required to provide segmentedinformation that allows the user to see theimpact of various segments on the overallcompany.


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Continued

Are the results of the ratio analysis consistent?

An analyst needs to look at several ratios inconjunction in order to form a sensible

conclusion. Total portfolio of the companyshould be used instead of only one set of ratios.

A company must be viewed along all these linessince the company may have strengths and/or

weaknesses in different areas. For example, ahighly profitable company may have very poorshort-term liquidity.


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Concerns

Is the ratio within a reasonable range forthe industry?

Analysts must look at a range of values fora particular ratio because a ratio can betoo high or too low.


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Accounting Issues Are alternative companies' accounting treatments

comparable? In comparing companies, even within the same

industry, the companies may be using differentaccounting treatments and/or different estimates to

capture the same event. Companies could use different estimates tocalculate depreciation or bad debts expense.Companies could use different inventory methodsand may have operating versus capital leases in

the financial statements. All of these accountingchoices and estimates affect financial statements.

However with IFRS replacing every countriesGAAP, the issue of distortion by accounting

treatment should be minimised.


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Looking Beyond The Numbers:

Good financial analysis involves more than just

calculating numbers.

There are Qualitative factors to be considered

when evaluating a companys future financialperformance.

These important and basic skills are necessary

when making business decisions, when

evaluating performance, and when forecasting

likely future developments.


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Ratio Analysis Limitations of Ratio Analysis:

Usefulness dependent on the

accuracy of the figures Enron,WorldCom or Parmalat? Only a part of the jig-saw needs

other information to make fulljudgement

What has happened in the past is

not necessarily a pointer to whatwill happen in the future! Statistics always have

a limitation in that it dependswhen they are used and how theyare used.

No two businesses are fullycomparable as the differencesbetween them will alwaysinfluence the performance of thebusiness

Ratios do not always reflect thedegree of intuition/genius that

may influence the performance ofa business

The Crooked E ironic logo ofEnron. Statistics do have theirlimitations!


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Are the companys revenues tied to a

single customer?

To what extent are the companys

revenues tied to a single product?

To what extent does the company rely ona single supplier?

What are some qualitative factors analystsshould consider when evaluating a

companys likely future financialperformance?


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Looking Beyond The Numbers:

Are the firms revenues tied to One key

customer, product, or supplier?

What percentage of the firms business is

generated overseas?

Competition.

Future prospects. Legal and regulatory environment.


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Qualitative Issues

The sustainability of an enterprise is notjust down to current profits.

Today's businesses need to care andrespect the environment.

CSR and Corporate Governance areessential.

Investors are waking up this andunderstand that sustainability is key.


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The End

limitations of analysis

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