Question

How would you respond to this post?

Ratio analysis provides a lot of information on a company regarding debt, liquidity, profitability, efficiency, per-share metrics, and relative value (Byrd, Hickman, & McPherson, 2013). However, there are potential pitfalls to using ratio analysis to measure a company. For example, comparing these numbers to the industry average might not be the best idea (Carlson, 2019). The industry average is, well, average; most people want to invest in companies that are more than even above average. To avoid this issue, potential investors should compare ratios to industry leaders instead. Another problem with ratio analysis is inflation (Carlson, 2019). Inventory depreciation is affected by inflation, so ratios, when compared over time, might not reflect what is going on with a company. To combat this issue, potential investors or financial managers should adjust the ratios to account for the inflation rate when comparing numbers over different periods. A more significant issue with ratio analysis is that ratios do not provide the “why,” only the “what” (Carlson, 2019). While doing the week five assignment, I noticed that Starbucks invested a lot of money and took on a lot of debt in 2018 (Starbucks, n.d.). This dramatic change was due to an acquisition in East China (Starbucks, n.d.). Without that information, the ratios may not make sense. Considering their assets, liabilities, income, and a bunch of other metrics dramatically changed, so did all of their ratios.

Answer 1

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Ratio analysis is used to describe relationships between different variables used in financial statements. It is extensively used to make comparison between different companies and between different time periods. Ratios can aid an analyst in judging a company's financial health, projecting earnings & free cash flow and evaluating activity and efficiency. It's a very powerful tool in the world of finance.

However, there are certain limitations of ratios arising due to heterogeneity of a company’s operating activities, inconsistency in the results of ratio analysis, judgment required for interpretation and different accounting methods used by different companies.

There are various limitations of ratio analysis:

• Ineffective when used in isolation; should be used in addition to other evaluation techniques.
• Makes sense only for comparison; meaningless unless it can be compared with historical values, peers or industry benchmarks.
• Purely quantitative, doesn’t capture the impact of qualitative factors
• Does not factor in external factors such as macroeconomic conditions, industry cycle, seasonality, change in accounting policy etc.
• Inflation may distort the outcome of financial analysis
• Needs too many adjustments for right comparison if peer set uses different accounting policies or are in different stages of growth
• Thrives on relative analysis, at times finding the appropriate peer set for a company with diversified business portfolio or operations gets very difficult; ratio analysis loses significance in the absence of appropriate peer set.
• Can help identify any outliers but then demand further probe to understand the reason.
• Like to like comparisons should be made so a company which has suffered substantial loss due to exceptional reason cannot be compared directly with the industry benchmark.
• Large companies with diverse business interests are difficult to compare using ratio analysis
• So many ratios have to be calculated, no single ratio can capture all the relevant information an investor need to know about the company.