As your text describes, ratio analysis is a common technique in financial analys

Question

As your text describes, ratio analysis is a common technique in financial analysis. One of your colleagues states that a thorough ratio analysis is all that is needed in considering the financial health of a company. Although you agree that ratio analysis is a helpful guide, there may be some potential pitfalls in ratio analysis. Discuss at least three potential issues in utilizing ratio analysis that you would share with your colleague. In addition, calculate a liquidity, profitability, and efficiency ratio from your Week Six company to demonstrate your observations. Develop a 200 – 300 word explanation supporting your findings. ATTENTION TUTORS NO COPY AND PASTE PLEASE

Explanation / Answer

No doubt that Ratio analysis is a good technique for analysing the performance of a company, however following limitations suggest that this technique have some consequences which one should take care before drawing any conclusion about a company:

Inflation. If the rate of inflation has changed in any of the periods under review, this can mean that the numbers are not comparable across periods. For example, if the inflation rate was 100% in one year, sales would appear to have doubled over the preceding year, when in fact sales did not change at all.

Accounting policies. Different companies may have different policies for recording the same accounting transaction. This means that comparing the ratio results of different companies may be like comparing apples and oranges. For example, one company might use accelerated depreciation while another company uses straight-line depreciation, or one company records a sale at gross while the other company does so at net.

Company strategy. It can be dangerous to conduct a ratio analysis comparison between two firms that are pursuing different strategies. For example, one company may be following a low-cost strategy, and so is willing to accept a lower gross margin in exchange for more market share. Conversely, a company in the same industry is focusing on a high customer service strategy where its prices are higher and gross margins are higher, but it will never attain the revenue levels of the first company.

Liquidity Ratio: Liquid Assets/ Current Liabilities

Liquid Assets = Current Assets- Stock

Now, different companies have different definition for Liquid Assets. E.g. Some Companies assume Raw Material as easily liquid stock where they use to sale the RM as well. However, other companies consider RM as current stock but not as Liquid Stock.   

Net Profit Ratio:Net Profit/ Net Sales

Net Profit may include some adjustments which may not be there in the past years or future years therefore comparing with previous year will certainly give wrong results to analyst and user of financial statements.

Efficiency Ratio: e.g. Debtors Turnover Ratio = Net Credit Sales/ Average Accounts Receivable

Now, Credit Sales may include Excise duty or may not include the excise duty and other taxes. So, different companies may follow different approach which will make the comparison useless.

So, in addition to Ratio analysis there are other techniques also which also to be followed for comparison e.g. Cash Flows, Variances, Net Contribution Margins etc. One should also refer the special items if any, in the Balncs Sheet and P&L.

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