Sub: Finance Topic: Financial Forecasting
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