Question

Ratio analysis is an important tool used by investors, creditors, and management when assessing the health of a company. However, ratio analysis has some problems and issues. What do you think are the problems and issues you must be aware of when conducting ratio analysis? What are the key ratios a creditor would investigate, and why?   

Answer 1

Ratio analysis is an important tools used by various stakeholder to assess the financial health of the company. It indicates one number in relation with the other. But, there are also some problems and issues involved with the ratio analysis.

- Ratio analysis involves the number and those numbers are derived from the previous financial statement. So, predicting the outcome of future event based on the historic data is very hard.

- It takes the data from the financial statement. So, we need to make sure that the data taken at the end of the period and not in midway.

- It will not be helpful in comparing the two companies which have different strategies.

- It's limitations lies with the interpretation of the ratio. It may show different pictures according to the interpretation. For example, if we have sufficient number of current assets as prescribed but those involves high portion of prepaid expenses and the ending stock. Then the company might feel a pressure to obligate its current liabilities.

- Comparing the ratio analysis for the firms operating in the different industries can be difficult. Because, different industry have different strategies.

So, I think these are some of the limitations and problems involved with the ratio analysis.

The following are the three keys ratios which I think a creditor should investigate with reasons;

- Debt service coverage ratio - This ratio tells whether the company will be able to pay all its obligations in a particular year. Because, creditors should the ability of the firm to pay all its liabilities within the time. It may be possible that previous and existing creditors are not happy with the debt servicing. And in that way it may create problem for the new ones.

- Leverage ratio - This ratio tells what portion of the business capital is actually financed by the outsiders. It is calculated by dividing total liabilities by the total assets. It is important as if more portion have been financed by various creditors then the ownership on the assets will be diluted. For a new creditors, the ownership will reduce as it is already highly leveraged.

- Current ratio - It indicates the ability to pay the current liability. It is important because a creditor want to know whether the company is able to generate enough cash from its operations. Current assets includes prepaid expenses and stocks etc. So, high level of current assets does not mean that the firm is having large amount of cash to pay of its current liabilities. So, the company must generate enough cash from its operation yearly to obligate its current liabilities.