LIMITATIONS OF RATIO ANALYSIS ON FINANCIAL ANALYSIS BASIC INFORMATION AND TUTORIALS

WEAKNESSES OF RATIO ANALYSIS IN FINANCE

Financial statement analysis is an attempt to work with the reported financial figures in order to asses the entity’s financial strengths and weaknesses. Most analysts tend to favor certain ratios.

Although other ratios may be of interest, depending on one’s perspective (i.e., manager, stockholder, investor, or creditor), there is no use in computing ratios of unrelated items such as sales returns to income taxes.

A banker, for example, is concerned with the firm’s liquidity position in deciding whether to extend a short term loan. On the other hand, a long-term creditor has more interest in the entity’s earning power and operating efficiency as a basis to pay off the debt at maturity.

Stockholders are interested in the long-run profitability of the firm since that will be the basis for dividends and appreciation in the market price of stock. Management, naturally, is interested in all aspects of financial analysis since they are concerned with how the firm looks to both the investment and credit communities.

Once a ratio is computed, it is compared with related ratios of the company, the same ratios from previous years, and the ratios of competitors. The comparisons show trends over a period of time and hence the ability of an enterprise to compete with others in the industry.

Ratio comparisons do not mark the end of the analysis of the company, but rather indicate areas needing further attention. Although ratio analysis is useful, it does have its limitations, some of which are listed below.

1. Many large firms are engaged in multiple lines of business, so that it is difficult to identify the industry group to which the firm belongs. Comparing their ratios with those of other corporations may be meaningless.

2. Operating and accounting practices differ from firm to firm, which can distort the ratios and make comparisons meaningless. For example, the use of different inventory valuation methods (LIFO versus FIFO) and different depreciation methods would affect inventory and asset turnover ratios.

3. Published industry average ratios are only approximations. Therefore, the company may have to look at the ratios of its major competitors, if such ratios are available.

4. Financial statements are based on historical costs and do not take inflation into account.

5. Management may hedge or exaggerate their financial figures; thus, certain ratios will not be accurate indicators.

6. A ratio does not describe the quality of its components. For example, the current ratio may be high but inventory may consist of obsolete goods.

7. Ratios are static and do not consider future trends.

Leverage (Solvency, Long-Term Debt) Ratios Basic Information and Tutorials

Solvency is a company’s ability to meet it long-term obligations as they become due. An analysis of solvency concentrates on the long-term financial and operating structure of the business.

The degree of long-term debt in the capital structure is also considered. Further, solvency is dependent upon profitability since in the long run a firm will not be able to meet its debts unless it is profitable.

When debt is excessive, additional financing should be obtained primarily from equity sources. Management might also consider lengthening the maturity of the debt and staggering the debt repayment dates.

Some leverage ratios follow.

Debt Ratio. The debt ratio compares total liabilities (total debt) to total assets. It shows the percentage of total funds obtained from creditors.

Creditors would rather see a low debt ratio because there is a greater cushion for creditor losses if the firm goes bankrupt.

Debt ratio = total liabilities/ total assets

For the Ratio Company, in 20X3 the debt ratio is: $135,400/ $220,000 = 0:62

In 20X2, the ratio was 0.63. There was a slight improvement in the ratio over the year as indicated by the lower degree of debt to total assets.