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Limitation of Ratio Analysis


The analysis in 1(b) is subject to the limitations as following:

1.      The analysis is not based on a trend analysis as only two-year balance sheets are provided while the other information is come from the accounting period concerned.  It is suggested to have five-year accounting information for performance comparisons and predictability purposes in order to achieve the best results.  Anything less than three years does not enable to plot much of a trend, and beyond five years the data can become somewhat out of date.

2.      There is no industry standard provided to compare with the data of the company.  For example, whether the average debtors collection period, average creditors payment period and inventory turnover of the company are normal would depend on the industry norm. 

3.      The analysis assumes that financial statements are prepared using the same accounting standards and convention.  However, the fact is that there are different accounting methods, size, and the diversification of product lines among different companies that would make direct comparison difficult and less meaningful.  For example, in the area of stock valuation, company A may has chosen First-In-First-Out (FIFO) method while company B may has decided to use weighted average method.  Similarly, in the area of fixed assets depreciation, Company A may favor straight-line method while Company B may decide to use sum-of-the-year-digits method and yet Company C may want to use reducing balance method.  Hence, it must be deal with care when this information is compared with other companiesíŽ figures.

4.      There is a lack of information about the internal and external environments.  These are factors which may influence the performance of the company.  In order to make the analysis more meaningful, we must also go beyond number and look at the qualitative aspects.  For example, the general state of the economy, the business environment the company is in (whether it is high technology or low technology, capital intensive or labor intensive, sunrise industry or sunset industry), the internal factors (quality and reputation of its senior management, the policies, business planning), etc. 

5.      Inflation is ignored as the analysis is based on historical cost.  Hence, there may be misleading information on the comparison of the two years data, for example debt ratio.

6.      Year-end data may not represent the actual position of the company during the year.  It is because the data can be manipulated by the management near the end of the year in an attempt to improve the ratio.  For example, the management may inject cash to pay off short-term debt to improve current ratio. 

7.      The data is analyzed subjectivity.  Hence, in order to have better funds flow analysis and share price movements, it is suggested to review trade journals, stock brokersíŽ reports, etc for detail information.

8.      The ratio analysis is based on the financial statements and accounting information provided from the company.  The report will provide misleading results if the quality of the underpinning financial information is poor.  For example, if there are poor estimates of depreciation, or bad debts.  Also, the information may be subject to modifications, supplementations and/or qualifications expressed in accompanying documents such as directorsíŽ reports and auditorsíŽ reports. 


Bibliography

Hoggett, John and Edwards, Lew (1996), Accounting in Australia, 3rd Edition, Jacaranda Wiley Australia

Gallagher, Timothy J and Andrew, Joseph D Jr (2002), Financial Management: Principles and Practice, 2nd Edition, Prentice Hall, Upper Saddle River, New Jersey


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