Question

Ratio analysis

A company reports accounting data in its financial statements. This data is used for financial analyses that provide insights into a company’s strengths, weaknesses, performance in specific areas, and trends in performance. These analyses are often used to compare a company’s performance to that of its competitors, or to its past or expected future performance. Such insight helps managers and analysts improve their decision making.

Consider the following scenario:

You work as an analyst at a credit-rating agency, and you are comparing firms in the construction and engineering sector. One company in the portfolio of companies you are analyzing is a Chinese firm. This firm stands out in the ratio analysis, because the company’s financial ratios are substantially lower than identical financial ratios of the other firms in the sector. You do not dissect the results of the ratio analysis and categorize report this firm as an under-performing company.

Which of the following statements about your analysis report is true?

The analysis likely includes incorrect and misleading conclusions.

The ratios provide an accurate and thorough representation of the Chinese company’s performance.

Most decision makers and analysts use five groups of ratios to examine the different aspects of a company’s performance. Indicate whether each of the following statements regarding financial ratios are true or false?

Statement	True	False
Debt or financial leverage ratios help analysts determine whether a company has sufficient cash to repay its short-term debt obligations.
Asset management or activity ratios provide insights into management’s efficiency in using a firm’s working capital and long-term assets.
A company exhibiting a high liquidity ratio means it is likely to have enough resources to pay off its short-term obligations.
Market-value or market-based ratios help analysts figure out what investors and the markets think about the firm’s growth prospects or current and future operational performance.
One possible explanation for an increase in a firm’s profitability ratios over a certain time span is that the company’s income has increased.

Ratio analysis is an important component of evaluating company performance. It can provide great insights into how a company matches up against itself over time and against other players within the industry.

However, like many tools and techniques, ratio analysis has a few limitations and weaknesses.

Which of the following statements represent a weakness or limitation of ratio analysis? Check all that apply.

A firm may operate in multiple industries.

A firm’s financial statements show only one period of financial data.

Different firms may use different accounting practices.

Answer 1

Explanning each of the statement is true or false with respect to ratio of that chinese
company:
Statement	True/False		My Comment
The analysis likely includes incorrect and misleading conclusions.	True		As this is chinese company, there may be different accounting policy. So financial ratio having limitation when there are different accounting policy. So it seems unfair and misleading information by including chinese firm's data.
The ratios provide an accurate and thorough representation of the Chinese company’s performance.	False		As this is chinese company, there may be different accounting policy. So financial ratio having limitation when there are different accounting policy. So it seems unfair to including chinese company's ratio with the other as not justified.
Most decision makers and analysts use five groups of ratios to examine the different aspects of a company’s performance.	True		Using five group ratio including Profitability, Liquidity, Leverage, Turnover and control ratio, a company can analyse it's financial performance and capacity.
Statement	True/False		My Comment
Debt or financial leverage ratios help analysts determine whether a company has sufficient cash to repay its short-term debt obligations.	False		Financial leverage ratio help to determine weightage of debt to equity or total assets.
Asset management or activity ratios provide insights into management’s efficiency in using a firm’s working capital and long-term assets.	True		Activity ratio analyse how effctively use the assets to generate revenue and cash
A company exhibiting a high liquidity ratio means it is likely to have enough resources to pay off its short-term obligations.	True		High Current ratio and Acid test ratio as above 2 and 1 respectively represent enough liquidity to pay short term liability
Market-value or market-based ratios help analysts figure out what investors and the markets think about the firm’s growth prospects or current and future operational performance.	False		Market based ratio is not used by company or management itself because these ratio does not focus on operational performance. These ratios are analysis by investor to determine market value or market performance before investment.
One possible explanation for an increase in a firm’s profitability ratios over a certain time span is that the company’s income has increased.	True		Gross profit or net profit on sales are example of profitability ratio. These ratio increased with many reason including income increased, expenses reduced, sales increased, etc.
Ratio analysis is an important component of evaluating company performance. It can provide great insights into how a company matches up against itself over time and against other players within the industry.	True		Ratio help in compare with it's previous year data, budgeted date and industries data. So it control if anything going wrong based on comparison.
There are limitation of financial ratio. One of the main limitation is different accounting policies and valuation method used in
preparation of financial statement in different companies. So while compare between two companies. It is necessary to carefully
analyse notes to accounts as part of financial statement for understanding of which accounting policy is used otherwise, ratio will
not give justified result.