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Limitations of Ratio Analysis

Essay by   •  April 3, 2011  •  Case Study  •  1,426 Words (6 Pages)  •  3,129 Views

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1. Explain some of the limitations of ratio analysis as part of financial statement analysis.

Ratios are a great way of determining the financial position of a company; however, they can also be misleading. Because ratios are based on numbers from the financial statements, they are limited to the validity of those statements. Also, not all companies prepare their financial statements exactly the same which makes it very difficult to analyze and understand ratios. Here are some limitations of ratio analysis:

The homogeneity of company's operating activities can make it difficult to find comparable industry ratios to use for comparison purposes. Companies may have divisions operating in many different industries and thus their ratios may not be meaningful when comparing them to other companies.

Also, ratios may indicate a problem in one area but in another they may prove that the potential problem is only short-term. Therefore, another limitation of ratios is that there is a need to determine whether the results of the ratio analysis are consistent throughout the organization.

There is a need to use judgment when using ratios. Analysts must consider the external economic and industry setting in which a company is operating when interpreting ratios. Using judgment can help in determining whether a company has in fact grown or become more risky.

Another limitation to ratios is the fact that the accounting methods used differ from company to company. For example, average cost inventory valuations cannot be compared when one company uses LIFO and another uses FIFO.

2. What is DuPont analysis and how do we use it?

DuPont Analysis is a method of disintegrating Return on Equity (ROE) into its component parts to explain how each aspect of performance affects the overall profitability of a company. It is used by managers to determine which area (or areas) they should focus on in order to improve ROE. Here is how we decompose ROE:

ROE= Net Profit Margin x Asset Turnover x Leverage

Companies can use this analysis internally to measure their own performance or also externally to measure the performance of other companies within their industry.

3. What is the International Standards Convergence? Include in your discussion some of the key areas where the convergence has the greatest impact (e.g. inventory valuation).

To begin this discussion it is important to distinguish our accounting standards setting board, better known as the FASB, between that of the International Accounting Standards Committee Foundation, the IASB. Instead of setting standards for the domestic nation, as is the objective of the FASB, the IASB's mission is to develop a single set of global reporting standards and to promote the use of those standards. To accomplish this, the International Standards Convergence project is a joint venture between our national standard setting boards and the IASB to bring about convergence between our national accounting standards and their international ones by eliminating differences between IFRS and U.S. GAAP. Some of the key areas where convergence has had the greatest impact are in the following:

* Inventories: Only two methods of inventory valuation are allowed, FIFO and weighted average cost. LIFO is not an option under IFRS.

* Asset Revaluation: Long term assets such as property, plant, equipment can be measured at historical cost less accumulated depreciation or at a revalued amount. Asset revaluation is not allowed under GAAP. Also, revaluation of intangible assets, such as goodwill, is allowed under IFRS but not in GAAP.

4. Explain why we do common-size analysis of balance sheets and income statement and how these analyses relate to trend analysis.

We do common-size analysis of balance sheets and income statements because it helps us compare the financial statements of different size companies. Common size statements express items, such as inventory, in proportion to their related measure, such as assets. The cool thing about doing common size analysis a financial analyst can find important changes in a business simply by revealing the trends in the common size ratios over the years. By doing a common size analysis of the balance sheet an analyst can figure out how a company has been financing itself, how is the company using its assets, and how one company's balance sheet composition different from another's and why.

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