216

USES AND LIMITATIONS OF RATIO ANALYSIS

SELF-TEST

QUESTIONS

“window dressing”
techniques
Techniques employed !~rr~

to moke their n~n~

statements look beset thoe
ockaify.
 Chapter 7 Analysts of Financial Statements

5
As notcd earlier, three main groups usc r.ttio analysis:

• Managers, who employ ratios to help anal)~zc, control, and thus improve the firm’s operations
• c’redlt analysts, such as bank loan officers or bond rating analysts, who analyze’ ratios to help ascertain a company’s ability to pay its debts
10 • Security analysts (or Investors), including stock analysts, who arc interested in a company’s efficiency and
growth prospects, and bond analysts, who arc cot~cerncd with a company’s ability to pay interest on its bonds and the liquidation value of the firm’s assets in the event
that the company fails.

Although ratio analysis can provide useful information concerning a company’s operations and financial condition, it does have inherent problems and limitations
15 that necessitate care and judgment. Some potential prOblems follow:

I. Many large firms operate a number oidivisions in vcry different industries. in such cases, It is difficult to develop a rncaningful set of industry averages for
comparative purposes. Consequently, ratio analysis tends to be more useful for small, narrowly focused firms than for large, rutiUidivisional ones.
2. Most firms want to hc better than average, so merely attaining avcr.tgc performance is not necessarily good. As a target for high-level performance, it is best to
20 focus on the industry leaders’ i.itios.
3. Inflation might distort firms’ balance sheets. For example, if recorded values are historical, they could bc
substantially different from the tnic” values. Furthermore, because inflation affects both depreciation charges and inventory costs, it also affects profits. For these reasons,
a ratio analysis for one firm over time, or a comparative analysis of firms of different ages, must be interpreted
with judgment.
25 4. Seasonal factors can distort a ratio analysis. For example, the inventory turnover ratio (or a textile firm will be radically different if the balance sheet
figure used for inventory is the one just before the fall fashion season versus the one just after the close of the season. You can minimize this problem by using monthly
averages for inventory (and receivables) when calculating ratios such as turnover.
5. Firms can employ “window dressing” techniques to make their financial statements look stronger. To
fliustrate, consider a Chicago builder that borrowed on a two-year basis on December 28, 2002, held the proceeds of the loan as cash for a few days, and then paid
30 off the loan ahead of time on January 2, 2003.This activity improved the compan~”s current and quick ratios, and It macic the firm’s year-end 2002 balance
sheet look good.Thc improvement Was
strictly window dressing, however; a week lat~r, the balance sheet was back at the old level.
6 Different accounting practices can dj~o~t comparisons. As noted earlier, inventory valuation and dcpr~clation ibethods can affect financial statements
and thus make comparisons among fi?n~s difficult.
35 7. It is difficult to generalize about whe.t~er a particular ratio is good0 or “bad. For example, a high current ratio might indicate a strong liquidity pos1t1°~