Question

1. “Financial Ratios calculated and analysed in a particular situation depend on the user of the financial statements” – Expound the advantages and limitations of ratio analysis
2. Give a brief summary of forecasting to determine additional (discretionary) funding (financing) needed.                                                                                    
3. “More can be said about risk, especially as to its nature, when we own more than one asset in our investment portfolio.” Define risk and explain how risk is affected if we diversify our investment by holding a variety of securities?
4. “Originally, the sole objective of the federal government in taxing income was to generate financing for government expenditures. Although this purpose continues to be important, social and economic objectives have been added.” Substantiate the statement with enough explanations.
5. The finance department of an enterprise performs several functions in order to achieve the above objectives. The scope of finance function is very wide.”   

Answer 1

Since, multiple questions have been posted and questions are not related to each other, I have answered the first one.

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Question a)

The following advantages and disadvantages are provided by ratio analysis:

Advantages:

1)

Financial Health:

Ratio analysis is frequently used to analyse the financial performance of the company over a period of time. It helps different users (such as investors, creditors, banks and financial institutions, etc) to understand the current financial situation/position and take decisions with respect to investment in the company or extend credit to the company.

2)

Operational Efficiency:

Ratio analysis helps in understanding the way the business operations are carried out by the management of the company. The more efficient the operations are, the more profitable the company is likely to be. Efficiency in business operations also indicate that the company is better able to control its costs and utilize its resources in the best possible manner.

3)

Comparison:

Ratios are used to compare the performance of companies operating within the same industry and also with the performance of companies/units operating in other industries. Comparative analysis is necessary to identify the problem/improvement areas and take appropriate steps/decisions to correct them. Such a comparison also helps in identifying the best practices followed by certain companies and implementing them to improve current business operations/practices/procedures.

4)

Simplification of Financial Statements:

Understanding of raw financial statements may be difficult for different groups of users because of complex accounting procedures/practices followed/applicable by/to the company. Ratio analysis serves as a standard measure that can be easily understood by all forms of users who may have limited accounting/financial knowledge.

5)

Budgeting and Future Planning:

Ratio analysis is also used for making financial projections. Pro-forma financial statements (such as income statement, balance sheet and cash flow statement) can be prepared with the use of information contained in current/previous year financial statements andvarious ratios. Based on such projections, the company can make appropriate arrangements to meet its future resource requirements and ensure that there is no adverse impact on business operations in the near future because of shortage of capital or other business resources.

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Disadvantages:

1)

Historical Information:

Ratios are calculated based on historical data/information available in the financial statements. Therefore, ratio analysis cannot be considered as an accurate indicator of the future financial financial performance/position of the company. Important factors such as inflation are ignored by ratio analysis. In other words, it wouldn't be appropriate to rely solely on the information provided by ratio analysis while making important future financial decisions (both for the company and the users).

2)

Ignorance of Qualitative Factors:

Ratio analysis is based on the figures available in the financial statements. It completely ignores the qualitative factors (such as quality of management, customer base, market share, etc.) that impact the day to day business operations of the company.

3)

Subject to Manipulation:

Companies often resort to measures that may impact the information available in the financial statements. In such a case, the ratios based on such data may not correctly represent the financial position/status of the company and may mislead the investors/users.

4)

Difficulty in Comparison:

Different companies operate in different business environments and are subject to different forms/types of internal and external factors. Therefore, any comparison made (between two companies) on the basis of ratios cannot be completely relied upon while making investment/financing decisions. Further, use of different accounting policies/procedures used by different companies may affect the overall comparison.