Limitation of Ratio Analysis Essays

Limitation of Ratio Analysis Essays Limitation of Ratio Analysis Essay Limitation of Ratio Analysis Essay Restriction of Ratio Analysis Learning Objective Explain to the participants on the restriction of ratio analysis. Important Footings Creative accounting. Accounting Policies. As we have alredy discussed, it is of import to compare in order to be able to analyze and to be able to notice and later urge in order that a concern is every bit efficient as possible. Restrictions of Ratios Accounting Information Different Accounting Policies The picks of accounting policies may falsify inter company comparings. Example IAS 16 allows rating of assets to be based on either revalued sum or at depreciated historical cost. The concern may choose non to appreciate its plus because by making so the depreciation charge is traveling to be high and will ensue in lower net income. Creative accounting The concerns apply originative accounting in seeking to demo the better fiscal public presentation or place which can be misdirecting to the users of fiscal accounting. Like the IAS 16 mentioned above, requires that if an plus is revalued and there is a reappraisal shortage, it has to be charged as an disbursal in income statement, but if it consequences in reappraisal excess the excess should be credited to revaluation modesty. So in order to better on its profitableness degree the company may choose in its reappraisal programme to appreciate merely those assets which will ensue in reappraisal excess go forthing those with reappraisal shortages still at depreciated historical cost. Information jobs Ratios are non unequivocal steps Ratios need to be interpreted carefully. They can supply hints to the company s public presentation or fiscal state of affairs. But on their ain, they can non demo whether public presentation is good or bad. Ratios require some quantitative information for an informed analysis to be made. Outdated information in fiscal statement The figures in a set of histories are likely to be at least several months out of day of the month, and so might non give a proper indicant of the company s current fiscal place. Historical costs non suited for determination devising IASB Conceptual model recommends concerns to utilize historical cost of accounting. Where historical cost convention is used, plus ratings in the balance sheet could be misdirecting. Ratios based on this information will non be really utile for determination devising. Fiscal statements certain summarised information Ratios are based on fiscal statements which are sum-ups of the accounting records. Through the summarization some of import information may be left out which could hold been of relevancy to the users of histories. The ratios are based on the summarised twelvemonth terminal information which may non be a true contemplation of the overall twelvemonth s consequences. Interpretation of the ratio It is hard to generalize about whether a peculiar ratio is good or bad . For illustration a high current ratio may bespeak a strong liquidness place, which is good or inordinate hard currency which is bad. Similarly Non current assets turnover ratio may denote either a house that uses its assets expeditiously or one that is under capitalised and can non afford to purchase adequate assets. Comparison of public presentation over clip Monetary value alterations Inflation renders comparings of consequences over clip misleading as fiscal figures will non be within the same degrees of buying power. Changes in consequences over clip may demo as if the endeavor has improved its public presentation and place when in fact after seting for inflationary alterations it will demo the different image. Technology alterations When comparing public presentation over clip, there is demand to see the alterations in engineering. The motion in public presentation should be in line with the alterations in engineering. For ratios to be more meaningful the endeavor should compare its consequences with another of the same degree of engineering as this will be a good footing measuring of efficiency. Changes in Accounting policy Changes in accounting policy may impact the comparing of consequences between different accounting old ages as misleading. The job with this state of affairs is that the managers may be able to pull strings the consequences through the alterations in accounting policy. This would be done to avoid the effects of an old accounting policy or derive the effects of a new one. It is likely to be done in a sensitive period, possibly when the concern s net incomes are low. Changes in Accounting criterion Accounting criterions offers standard ways of recognising, mensurating and showing fiscal minutess. Any alteration in criterions will impact the coverage of an endeavor and its comparing of consequences over a figure of old ages. Impact of seasons on trading As stated above, the fiscal statements are based on twelvemonth terminal consequences which may non be true contemplation of consequences twelvemonth unit of ammunition. Businesss which are affected by seasons can take the best clip to bring forth fiscal statements so as to demo better consequences. For illustration, a baccy turning company will be able to demo good consequences if histories are produced in the merchandising season. This clip the concern will hold good stock list degrees, receivables and bank balances will be at its highest. While as in seting seasons the company will hold a batch of liabilities through the purchase of farm inputs, low hard currency balances and even nil receivables. Inter-firm comparing Different fiscal and concern hazard profile No two companies are the same, even when they are rivals in the same industry or market. Using ratios to compare one company with another could supply misdirecting information. Businesss may be within the same industry but holding different fiscal and concern hazard. One company may be able to obtain bank loans at reduced rates and may demo high geartrain degrees while as another may non be successful in obtaining inexpensive rates and it may demo that it is runing at low pitching degree. To un informed analyst he may experience like company two is better when in fact its low geartrain degree is because it can non be able to procure farther support. Different capital constructions and size Companies may hold different capital constructions and to do comparing of public presentation when 1 is all equity financed and another is a geared company it may non be a good analysis. Impact of Government influence Selective application of authorities inducements to assorted companies may besides falsify intercompany comparing. One company may be given a revenue enhancement vacation while the other within the same line of concern non, comparing the public presentation of these two endeavors may be misdirecting. Window dressing These are techniques applied by an entity in order to demo a strong fiscal place. For illustration, MZ Trucking can borrow on a two twelvemonth footing, K10 Million on 28th December 2003, keeping the returns as hard currency, so pay off the loan in front of clip on 3rd January 2004. This can better the current and speedy ratios and do the 2003 balance sheet expression good. However the betterment was purely window dressing as a hebdomad subsequently the balance sheet is at its old place. Ratio analysis is utile, but analysts should be cognizant of these jobs and do accommodations as necessary. Ratios analysis conducted in a mechanical, unreflective mode is unsafe, but if used intelligently and with good opinion, it can supply utile penetrations into the house s operations.