Welcome to Scribd, the world's digital library. Read, publish, and share books and documents. See more
Download
Standard view
Full view
of .
Look up keyword
Like this
0Activity
0 of .
Results for:
No results containing your search query
P. 1
Uses and Limitations of Ratio Analysis

Uses and Limitations of Ratio Analysis

Ratings: (0)|Views: 6 |Likes:
Published by ClassOf1.com
Ratio analysis involves comparisons. A company’s ratios are compared with those of other firms in the same industry—that is, with industry average figures
Ratio analysis involves comparisons. A company’s ratios are compared with those of other firms in the same industry—that is, with industry average figures

More info:

Categories:Types, School Work
Published by: ClassOf1.com on Aug 02, 2013
Copyright:Attribution Non-commercial

Availability:

Read on Scribd mobile: iPhone, iPad and Android.
download as PDF, TXT or read online from Scribd
See more
See less

08/02/2013

pdf

text

original

 
 
Finance
LEARN TO EXCEL
Homework Help
24/7 Support
Step-by-Step Solutions
Experienced TutorsDetailed Explanationwww.classof1.com/homework-help/financeToll Free: 1-877-252-7763
 
 
Sub: Finance Topic: Financial Forecasting
*
The Homework solutions from Classof1 are intended to help students understand the approach to solving the problem and not forsubmitting the same in lieu of their academic submissions for grades.
Uses and Limitations of Ratio Analysis
Ratio analysis invol
 ves comparisons. A company’s ratios are compared with those of 
other firms in the same industry 
that is, with industry average figures. Ratio
analysis provides useful information concerning a company’s operations and
financial condition, but it has limitations that necessitate care and judgment.Some potential problems include the following.
 
Many large firms operate different divisions in different industries, and forsuch companies it is difficult to develop a meaningful set of industry averages.Therefore, industry averages are more applicable to small, narrowly focusedfirms than to large, multidivisional ones.
 
To set goals for high-level performance, it is best to benchmark on the industry 
leaders’ ratios rather than the industry average ratios.
 
 
Inflation may have badly distorted firms’ balance sheets—
reported values are
often substantially different from “true” values.
Further, because inflationaffects depreciation charges and inventory costs, reported profits are alsoaffected. Thus, inflation can distort a ratio analysis for one firm over time or acomparative analysis of firms of different ages.
 
Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio for a food processor will be radically different if the balancesheet figure used for inventory is the one just before versus the one just after
 
 
Sub: Finance Topic: Financial Forecasting
*
The Homework solutions from Classof1 are intended to help students understand the approach to solving the problem and not forsubmitting the same in lieu of their academic submissions for grades.
the close of the canning season. This problem can be minimized by usingmonthly averages for inventory (and receivables) when calculating turnoverratios.
 
Firms can employ “window dressing” techniques to make their financial
statements look stronger. To illustrate, suppose a company takes out a 2-yearloan in late December. Because the loan is for more than one year, it is notincluded in current liabilities even though the cash received through the loan isreported as a current asset. This improves the current and quick ratios andmakes the year-end balance sheet look stronger. If the company pays the loan back in January, then the transaction was strictly window dressing.
 
Companies’ choices of different
accounting practices can distort comparisons.For example, choices of different inventory valuation and depreciationmethods affect financial statements differently, making comparisons amongcompanies less meaningful. As another example, if one firm leases a substantialamount of its productive equipment, then its assets may appear low relative tosales (because leased assets often do not appear on the balance sheet) and itsdebt may appear low (because the liability associated with the lease obligationmay not be shown as debt). Conducting ratio analysis in a mechanical,unthinking manner is dangerous, but when ratio analysis is used intelligently 
and with good judgment, it can provide useful insights into a firm’s operations
and identify the right questions to ask.

You're Reading a Free Preview

Download
/*********** DO NOT ALTER ANYTHING BELOW THIS LINE ! ************/ var s_code=s.t();if(s_code)document.write(s_code)//-->