Question

A colleague has suggested that your company should invest in The End Game Limited and that all you need to do to decide whether it is a good idea or not is to get a copy of their financial statements. They said that the only type of analysis required will be to use ratio analysis and that should provide you with all the answers.

Required

Looking at the information that is used in ratio analysis, coming from the financial statements and the notes, write a report to your colleague highlighting and discussing three limitations of using ratio analysis as your major analysis method.

(Total 8 marks)

(3 marks will be awarded for the style of the business report, the presentation of the content, and the use of Business English)

Answer 1

Report on limitations of ratio analysis:

Ratio analysis is an important analytical tool for analysis of financial statements. However it has its own limitations. The following are the limitations of ratio analysis as analytical tool

· Ratio analysis is based on historical cost which is past information. Hence it does not help much in future prediction. It is post mortem analysis of the existing financial statements

· Ratio analysis may promote the management to do window dressing of its financial statement in order to show better results for the specified requirements. For example: Current ratio of 2 can be maintained by building inventory for meeting bank requirements to grant loan. Hence it promotes unethical behaviour to show better results.

· Ratio analysis does not consider the inflationary and seasonal effects. Inflation of costs is totally ignored in the ratio computation. It considers the 2 points in calculation of ratio the movement of which can be due to inflation. Seasonal effects of business are ignored in ratio and it may lead to false interpretation of numbers for seasonal businesses.