Question

Prepare NOTES for the following essay question from a past Exam. Discuss the strengths and weaknesses of models which incorporate ratios that an analyst could use to predict financial distress

Answer 1

Strengths of ratio models to predict financial distress are :

• Ratios are mostly simple to calculate
• The information required to compute ratios are available in the financial statements
• Ratios can detect signs of financial distress by analysing liquidity position, financial leverage, interest coverage ratios, profitability ratios and activity ratios
• Ratios are easy to explain and understand

Weaknesses of ratio models to predict financial distress are :

• The distress may be due to off-balance sheet items such as large amounts of financial obligations which are not recorded in the financial statements
• Ratios although useful for an overall analysis to quickly detect signs of distress, are not as useful for in-depth analysis and to detect signs which are hidden deep in the financial statements
• Signs of financial distress are sometimes detected by talking to suppliers, customers, employees, management etc., and not by analysis of financial statements