PART 1
Financial Ratios are very good at looking back to where the company has been and what the company has been through; take for example a recession. It’s like giving you a rear-view mirror while the company is driving forward. However, Financial Ratios have their limitations such as predicting future numbers. An example would be the inflation we have today. Now, every business knows what elements are needed to make the perfect storm for an inflation to occur however, who would have thought that a pandemic would have caused an inflation? Let alone, a pandemic occurring the first place. Although Financial Ratios can show possible trends for the company and perhaps highlight problems when moving forward however, they do not offer solutions. And while moving forward, the market can change as well.
Liquidity Ratios can convert a company’s assets to cash. However, assets can involve the company’s inventory. If the inventory is high, then this is a sign of fewer sales. Therefore, having a high inventory will not provide the precise calculation for liquidity. Activity Ratios calculate the efficiency of the company’s operations. However, they do not provide the results to compare with other competitors in the market. Leverage Ratios determines how much purchase a company can compensate for. However, it is poor measure for risk. Profitability Ratios are of course, measuring a company’s profits. However, if the profits are fraudulent or fabricated like the real case scenario of Enron, miscalculations will be hazardous to investors. All of these limitations are based are on what occurs in an ever-changing market.
Reference
Dobosz, J. (2013). Ten ratios to make you money in stocks. Forbes. Retrieved from http://www.forbes.com/sites/johndobosz/2013/09/25/10-ratios-to-make-you-money-in-stocks/ (Links to an external site.)
Epstein, L. (2014). Financial decision making: An introduction to financial reports. Zovio. https://content.uagc.edu/
PART 2
Ratio analysis is one of the most common tools used by companies to analyze financial statements. These analysis help in breaking down the most critical elements of the finances to review quickly. However, there are limitations to financial ratio analysis that must be considered. “There are certain limitations for ratio analysis as it only considers quantitative aspects and fully ignores the qualitative aspects, it does not take into consideration the reasons for fluctuation or amount due to which results may not be appropriate and in only shows the comparison or trend” (Vaidya, 2021). When analyzing each segmentation of ratio analysis below, it can be be shown that each sufferers from limitations:
Liquidity Ratios – Ratios that measure the availability of cash to fund operations and pay off short-term debt
Activity Ratios – Ratios that measure how efficiently and effectively a company uses resources
Leverage Ratios – Ratios that measure wether a company can repay long-term debt
Profitability Ratios – Measure the company’s rates of returns from various perspectives
Each of the following limitations can apply to one or all of the ratio analysis:
· Size of the business is not considered
· Contingent Liability is not taken into account
· Uniform accounting policies are not incorporated
· Can be susceptible to creative accounting practices
· Cannot compare different industries
· Based on Historical information only
· Inflation not taken into consideration
· Market conditions are not taken into consideration
· They do not capture seasonality
· Only consider a company position on a particular date.
The quality of a financial statement is determined upon the accuracy of ratio analysis and how the financial statements are manipulated to present a position that is better than many actually exist. Utilization of ratio analysis can be a quick way to look at a companies financial health, but should be utilized in conjunction with the other financial documents we have discussed during this course.
Epstein, L. (2014). Financial decision making: An introduction to financial reports. Retrieved from https://content.Jaycee.edu/
Vaidya, D. (2021). Ratio Analysis Limitations. WallStreetMojo. Retrieved from https://www.wallstreetmojo.com/ratio-analysis-limitation/
