Question

TOPIC 8 DQ: Limitations of Financial Ratio Analysis As the background paper, Financial Ratio Analysis, explains, a pervasive weakness of financial ratios is that they do not permit managers and others to assess the long-run sustainability of a business’ operations within a society.

a. Develop a ratio that a business might use to measure the impact of its operations on:

• The communities in which it is located, or the customers that use its products,

• The natural environment, or

• The health and safety of its employees

b. Provide the definition of the ratio, its proper interpretation, and the limitations on its usefulness for its intended purpose.

Answer 1

Financial ratios are not very useful on a stand-alone basis; they must be benchmarked against something.

There are some important limitations of financial ratios that analysts should be conscious of:

• Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios.
• Inflation may have badly distorted a company's balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment.
• Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the back-to-school season. As a result, the company's accounts payable will be high and its ROA low.
• Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.).
• It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations.
• A company may have some good and some bad ratios, making it difficult to tell if it's a good or weak company.

b.) Ratio analysis is a useful management tool that will improve your understanding of financial results and trends over time, and provide key indicators of organizational performance. Managers will use ratio analysis to pinpoint strengths and weaknesses from which strategies and initiatives can be formed. Funders may use ratio analysis to measure your results against other organizations or make judgments concerning management effectiveness and mission impact.

Limitations on its usefulness :

Financial ratios are a useful tool to track changes in business over time.The ratios will not be comparable because the valuations are not comparable.

Ratios tell a business owner what happened but they do not tell him why it happened. Business owners must dig deeper into the numbers to determine why ratios are changing from period to period.

This is one of the largest problems with relying on financial ratios. Because the financial statements are prepared based on book value (largely historical cost), they do not reflect current reality in the business.

Financial ratios, like the financial statements they are based on, do not capture all of the important information that tells stakeholders how the business is doing today and helps them predict where it is going in the future.