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.
Historical Information: Information used in the analysis is based on past results. Therefore, ratio analysis metrics don’t represent the future of the company.
Inflationary effects: Financial statement are released periodically and there are time differences between each release. If inflation has occurred then real prices are not reflected in the financial statements.
Change in accounting policies: If the company has changed its accounting policies and or procedures, this may significantly affect the financial reports.
Seasonal effects: An analyst should be aware of seasonal factors that could potentially result in limitations of ratio analysis. The inability to adjust the ratio analysis to the seasonality effects may lead to false interpretations of the results.
References:
Corporate Finance Institute [CFI]. (n.d.). Limitations of Ratio Analysis. Retrieved from: https://corporatefinanceinstitute.com/resources/knowledge/finance/limitations-ratio-analysis/ (Links to an external site.)
Respond to…
Analysis of the formula is all that is required when assessing a company’s financial wellbeing. Examination of the ratio is one important matter and it should not be the only examination used. In addition, if we treat ratio analysis as the end-all decision-making answer, we are doomed to failure. The manager and analyst must be concerned with how ratios can help explain share price behavior according to Byrd (2013).
Ratio analyzes are also very useful in that they can help isolate the company’s performance in a particular area such as inventory management, and are easily compared with the company’s historical norms and industry (Byrd, et al., 2013). “An analyst could easily get lost in looking at the ratios and lose track of the primary objective of financial management — maximizing shareholder wealth” (Byrd, 2013).
One potential issue is the historicity of the information. Historical data doesn’t mean future results will be the same. Inflation is another matter. Inflation rate may fluctuate over a period of time, and is not comparable. Companies have different procedures for the accounting. So if a company uses a reference, depending on that moment of time, it could be absolute off. We can’t extrapolate the future precisely from that one single moment. There’s no sense in there. The history is not helpful. There is no supporting information except for what is captured in that one frame.
