Ratio analysis provides an indication of a company’s liquidity, gearing and solvency. But ratios do not provide answers; they are merely a guide for management and others to the areas of a company’s weaknesses and strengths (Palat 1999).
However, ratio analysis is difficult and there are many limitations. This section will identify and discuss the inadequacies of accounting ratios as tools of financial analysis.
ACCOUNTING POLICIES.
It is difficult to use ratios to compare companies, because they very often follow different accounting policies. For example, one company may value stock under the LIFO principle, another may follow the FIFO principle. Similarly, one company may depreciate assets under the straight line method, while its competitors may be using reducing balance method. Also, one company may value their assets using the historical cost rule while another may use the alternative accounting rule. Other areas in which policies may differ between companies include development cost deferral policy, capitalisation of interest costs, etc.
SKILL OF ANALYST
In other to state whether a ratio is good or bad it must be intelligently interpreted. For example, a high current ratio may indicate, on the one hand, a liquidity position (which is positive) and, on the other excessive liquid cash (which is negative).
The Term Paper on Life Cycle Cost Analysis
Life-cycle cost analysis (LCCA) is a method for assessing the total cost of facility ownership. It takes into account all costs of acquiring, owning, and disposing of a building or building system. LCCA is especially useful when project alternatives that fulfill the same performance requirements, but differ with respect to initial costs and operating costs, have to be compared in order to select ...
RETURN ON EQUITY
A direct comparison between the Return On Equity (ROE) of different firms may not always be meaningful. Apart from national or industrial differences in the accounting or business practices the risk of firms may well differ. For example, a firm with high gearing would be expected to earn a higher ROE than would a firm with low gearing. This would be expected to earn a higher
ROE than would a firm with low gearing. This will be compensated for by a higher risk but this is not incorporated in the ROE measure.
RETURN ON CAPITAL EMPLOYED
The computation of Return On Capital Employed (ROCE) attempts to relate the net income to all sources of capital to the total value of capital contributions. Thus the income is taken before interest, minority interest, etc., and the capital includes equity, minority interest and all sources of interest-bearing debt, be they short or long term. It may be difficult to identify all the debt on the balance sheet and some analysts treat some provisions as part of equity. However, if these provisions are genuine estimates of forthcoming tax and pension liabilities they should be excluded from equity.
It could be argued that the income from associated companies and other income should be included, and miscellaneous creditors and provision may well include elements of capital. Some analysts insist on adding back provisions as they view this as an accounting allocation of equity for which a liability is unlikely even to appear (Walsh 1996).
LIQUIDITY MEASURES
As with all other groupings of ratios a number of alternative measures may be used which either alter the focus of the analysis, marginally alter the definition, or concentrate on a larger or smaller element of the dimension under investigation. Thus the most common measure of liquidity is the current liabilities on the rather rough approximation that assets may be used to pay off liabilities. Many analysts find it rather misleading to assume that stock may be used to pay off liabilities and narrow the definition of current assets to exclude stock and work-in-progress (called ‘quick or ‘acid test’ ratio).
The Essay on Debt and Equity
Long-term financing requires a meticulous understanding of the various features of debt and equity and their impact an organization. While evaluating debt and equity, an investment banker also has to consider the unique characteristics of the organization’s dealings while ensuring that the organization’s requirements are met. Debt CapitalDebt capital includes all long-term borrowing ...
Still others focus on the ratio of debt to alternative definitions of cash generation, or on the number of days the firm could survive if cash generation ceased – the no credit interval (Fridson 1995).
It is generally suggested that the current ratio should be 2:1, so that if, at worst, the current assets realise only 50 percent of their book value, the entity would still be able to meet its current liabilities in full. Similarly, the quick ratio should be 1:1, the reason being that in a going concern, the shelves have to remain filled up with goods, which means that the resources tied up in stock cannot be released to meet liabilities. However, this rule of thumb depends on the nature of the business: businesses such as supermarket operate on a ‘just in time’ stock policy and aim at very high stock turnaround, and this means that they can survive with a lower current ratio and quick ratio of 2:1 and 1:1 respectively (Benedict & Elliott 2001).
MANIPULATIONS
A ratio can be purposely distorted deliberately by a company to make it look better than it actually is. For example, a company could sell its debts at a discount for cash and as a result its collection ratio of debtors would be low, leading one to believe its efficiency to be greater than it actually is. Similarly, transactions prior to the balance sheet date may be reversed immediately after the balance sheet date (‘window dressing’).
Other examples where manipulation could take place include finance lease engineered as operating lease, off balance sheet financing, etc.
GEARING
The definition of gearing varies amongst analyst. Some analyst use the all inclusive one of long, medium, and short term loans divided by equity. Some analysts include preferred stock as debt as it behaves as if it were debt and possibly overdrafts and other interest-bearing debt which may be classified as creditors but could be included. An alternative to using the balance sheet to calculate gearing is to use the profit & loss statement and many analysts will examine the interest cover. Also, many analyst replace the book value of equity with the market value (Chen & Shimerda 2001).
The Essay on Inventory Accounting, Auditing, And Balance Sheet Components
1. Inventories are properly stated at the lower of cost or market. 2. Inventories included in the balance sheet are present in the warehouse on the balance sheet date. 3. Inventory quantities include all products, materials, and supplies on hand. 4. Liens on the inventories are properly disclosed in notes to the financial statements. 5. The client has legal title to the inventories. 6. The ...
DIVERSIFICATION
Many firms are very diversified, engaging in a number of different activities. This makes it difficult to develop a meaningful set of averages in order to compare performance.
INFLATION
Since the assessment of business performance rests on analysis of historical accounting and operating data, the main distortions caused by inflation must be recognised. Most important is the problem of historical costing. Depreciation and amortisation reflect lower past, not current values; and particularly in industries with long-lived capital equipment and physical resources, profits (and taxes) thus tend to be overstated in times of inflation. Comparisons will be hampered between companies with different ages of capital equipment, as an example. Similar, shorter term distortions are caused by inventory values changing rapidly, and various methods of costing are used to provide a consistent basis for analysis. Other issue involves the impact of inflation on borrowing, since declining values of the currency will reduce the economic burden of repayment to the borrower, while reducing the attractiveness of the loan to the lender. Current operations are also affected by differential price movements both in the goods and services sold, and in the factor costs of the operations carried out (Helfert 1992).
ACCOUNTING ESTIMATION
Ratios based on accounting numbers incorporate, and sometimes exaggerate, the limitations of accounting statements. The exaggeration comes when the two constituents of a ratio are biased in opposite directions and dividing one by the other expands the error. For example, during inflationary times accounting profits of industrial and commercial firms are often overstated whilst the balance sheet assets, and hence the equity, are often understated. A return on equity measure is therefore affected by two multiplicative errors (Rees 1995).
UNAVAILABLE DATA
Unfortunately, the financial reports of private companies in particular are often severely delayed, and even quoted companies may require up to three months to prepare their annual report and accounts. Furthermore, the analyst will often be concerned with a subsidiary or division of the company published financial statements and these results may not be available.
The Essay on Integers: Negative And Non-negative Numbers And Absolute Value
Integers are the first numbers that we learn to use. Along with their usefulness in everyday life, integers are building blocks from which all others numbers are derived. The integers are all the whole numbers including zero, all negative and all the positive numbers Basics of integers * Whole numbers greater than zero are called positive integers. These numbers are to the right of zero on the ...
UNSYNCHRONISED DATA
Companies accounting year-ends are varied which means that inter-company comparisons are often between accounting reports covering different periods. This problem must be especially severe for firms that deal in commodities for which the price is erratic. For example, the balance sheets of two petroleum firms might be very different if separated by six months which span one of the all too frequent substantial shifts in oil prices.
NON-STANDARDISED ACCOUNTING
Accounting policies and practices can vary between companies with little to guide the analyst, save minimally informative policy statements, and the loose constraints imposed by the various elements of the regulatory system. The difficulties created are especially severe where the scope of the review crosses national boundaries, and accounting policies become susceptible to varying regulatory prescriptions and may be ineffectively monitored or enforced.
NEGATIVE NUMBERS AND SMALL DIVISORS
Negative numbers can be problematical where a transformation of the original data is required, possibly to approximate better to a normal distribution or where a ratio is to be calculated by dividing through by a negative. Thus a loss of m on a firm with a negative equity of m will appear to be earning a return on equity of 100 percent
Equally difficult are the extreme ratio values that are calculated when dividing by a very small number. For example, earnings growth is problematic because earnings is an erratic variable and may in any one year be unusually small or negative.
