Question

.Read the quote and discuss what you think the author means by ‘passively calculating standard ratios’.

Corporations have substantial incentives to exploit the fact that accounting principles are neither fixed for all time nor so precise as to be open to only a single interpretation. Analysts, who appreciate the magnitude of the economic stakes, as well as the latitude available under the accounting rules, will see clearly that a verdict derived by passively calculating standard ratios may prove dangerously naive.

Source: Fridson, M & Fernando, A 2002, Financial statement analysis: a practitioner’s guide, 3rd edn, John Wiley & Sons, New York

Answer 1

‘passively calculating standard ratios’

Many of the ratios that we calculate rely on the asset, liability or equity numbers reported on the balance sheet. This report reflects the financial position of an ongoing entity at a particular date and may not be representative of the financial position at other times of the year.

Financial statements are historical statements reflecting past transactions. Often, the past is a good guide to the future; however, the use of information outside the financial statements needs to be considered when forming predictions as to an entity’s future financial health.

The author means that the limitations of the analytical process need to be considered, when interpreting and relying on ratios to form an opinion as to an entity’s financial health, both past and present. ‘Passively calculating standard ratios’ without the consideration of the above limitations would lead to an incomplete analysis.