Inadequacies of Accounting Ratios as Tools of Financial Analysis.

1481 WordsNov 17, 20056 Pages
Ratio analysis provides an indication of a company's liquidity, gearing and solvency. But ratios do not provide answers; they are merely a guide for management and others to the areas of a company's weaknesses and strengths (Palat 1999). However, ratio analysis is difficult and there are many limitations. This section will identify and discuss the inadequacies of accounting ratios as tools of financial analysis. ACCOUNTING POLICIES. It is difficult to use ratios to compare companies, because they very often follow different accounting policies. For example, one company may value stock under the LIFO principle, another may follow the FIFO principle. Similarly, one company may depreciate assets under the straight line method, while its…show more content…
However, this rule of thumb depends on the nature of the business: businesses such as supermarket operate on a 'just in time' stock policy and aim at very high stock turnaround, and this means that they can survive with a lower current ratio and quick ratio of 2:1 and 1:1 respectively (Benedict & Elliott 2001). MANIPULATIONS A ratio can be purposely distorted deliberately by a company to make it look better than it actually is. For example, a company could sell its debts at a discount for cash and as a result its collection ratio of debtors would be low, leading one to believe its efficiency to be greater than it actually is. Similarly, transactions prior to the balance sheet date may be reversed immediately after the balance sheet date ('window dressing'). Other examples where manipulation could take place include finance lease engineered as operating lease, off balance sheet financing, etc. GEARING The definition of gearing varies amongst analyst. Some analyst use the all inclusive one of long, medium, and short term loans divided by equity. Some analysts include preferred stock as debt as it behaves as if it were debt and possibly overdrafts and other interest-bearing debt which may be classified as creditors but could be included. An alternative to using the balance sheet to calculate gearing is to use the profit & loss statement and many analysts will examine the interest cover. Also, many analyst replace the book value of equity with the
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