Limitation of Ratio Analysis

Limitation of Ratio compendLimitation of Ratio Analysis Learning Objective Explain to the participants on the limitation of balance analysis. authorized Terms Creative write up. accounting Policies.As we have alredy discussed, it is signifi sightt to comparability in order to be competent to analyse and to be able to comment and subsequently recommend in order that a melody is as efficient as possible.Limitations of Ratios report Information diverse Accounting PoliciesThe choices of accounting policies whitethorn distort inter association comparisons. Example IAS 16 al slumps valuation of as inureds to be based on either give noticed amount or at depreciated historical cost. The business whitethorn opt not to revalue its asset because by doing so the depreciation charge is going to be high and get out result in lower profit. Creative accounting The businesses apply creative accounting in trying to show the recrudesce pecuniary performance or position which can be lead astray to the users of financial accounting. Like the IAS 16 menti peerlessd above, requires that if an asset is revalued and in that location is a followup deficit, it has to be charged as an expense in income statement, but if it results in review surplus the surplus should be credited to revaluation reserve. So in order to improve on its profitability level the company may select in its revaluation programme to revalue solely those assets which allow result in revaluation surplus leaving those with revaluation deficits still at depreciated historical cost.Information problems Ratios argon not determinate measuresRatios need to be interpreted c arefully. They can declare oneself clues to the companys performance or financial situation. But on their own, they cannot show whether performance is bang-up or bad.Ratios require some quantitative information for an informed analysis to be made. Outdated information in financial statementThe figures in a set of accounts are homogeneously to be at least several months push through of date, and so might not give a proper trait of the companys current financial position. Historical costs not suitable for finis making IASB Conceptual framework recommends businesses to use historical cost of accounting. Where historical cost convention is used, asset valuations in the balance sheet could be misleading. Ratios based on this information go out not be in truth useful for decision making. Financial statements certain summarised informationRatios are based on financial statements which are summaries of the accounting records. Through the summarisation some important information may be left out which could have been of relevance to the users of accounts. The dimensions are based on the summarised year end information which may not be a true reflection of the oerall historic period results. Interpretation of the ratioIt is difficult to generalise about whether a particular ratio is good or bad. For exam ple a high current ratio may indicate a strong liquidity position, which is good or excessive cash which is bad. Similarly Non current assets turn all over ratio may denote either a firm that uses its assets efficiently or whiz that is under capitalised and cannot afford to buy enough assets. Comparison of performance over time Price transmutesInflation renders comparisons of results over time misleading as financial figures will not be deep down the same levels of purchasing power. Changes in results over time may show as if the go- forth has ameliorate its performance and position when in fact after adjusting for inflationary changes it will show the different picture. Technology changesWhen comparing performance over time, there is need to consider the changes in technology. The movement in performance should be in aura with the changes in technology. For ratios to be more meaningful the enterprise should compare its results with another of the same level of technology as this will be a good basis measurement of efficiency. Changes in Accounting policyChanges in accounting policy may affect the comparison of results among different accounting years as misleading. The problem with this situation is that the directors may be able to manipulate the results through the changes in accounting policy. This would be do to avoid the effects of an old accounting policy or gain the effects of a new one. It is likely to be done in a sensitive period, perhaps when the businesss profits are low. Changes in Accounting standardAccounting standards offers standard ways of recognising, measuring and presenting financial transactions. Any change in standards will affect the reporting of an enterprise and its comparison of results over a number of years. Impact of seasons on tradingAs stated above, the financial statements are based on year end results which may not be true reflection of results year round. Businesses which are affected by seasons can choose the b est time to produce financial statements so as to show better results. For example, a tobacco growing company will be able to show good results if accounts are produced in the interchange season. This time the business will have good inventory levels, receivables and beach balances will be at its highest. While as in set seasons the company will have a lot of liabilities through the obtain of farm inputs, low cash balances and even nil receivables. Inter-firm comparison Different financial and business risk profileNo two companies are the same, even when they are competitors in the same industry or market. Using ratios to compare one company with another could provide misleading information. Businesses may be within the same industry but having different financial and business risk. i company may be able to obtain bank loans at reduced rates and may show high railroad train levels dapple as another may not be successful in obtaining cheap rates and it may show that it is ope rating at low gearing level. To un informed analyst he may feel like company two is better when in fact its low gearing level is because it can not be able to secure advertize funding. Different capital structures and sizeCompanies may have different capital structures and to fetch comparison of performance when one is all equity financed and another is a geared company it may not be a good analysis. Impact of Government influenceSelective application of government incentives to various companies may alike distort intercompany comparison. One company may be given a tax holiday while the other within the same line of business not, comparing the performance of these two enterprises may be misleading. window dressingThese are techniques applied by an entity in order to show a strong financial position. For example, MZ Trucking can borrow on a two year basis, K10 Million on 28th December 2003, holding the proceeds as cash, then pay off the loan ahead of time on 3rd January 2004. This can improve the current and diligent ratios and make the 2003 balance sheet look good. However the improvement was strictly window dressing as a week later the balance sheet is at its old position. Ratio analysis is useful, but analysts should be aware of these problems and make adjustments as necessary. Ratios analysis conducted in a mechanical, unthinking manner is dangerous, but if used intelligently and with good judgement, it can provide useful insights into the firms operations.