Journal on Financial Ratio Analysis

1157 Words Oct 17th, 2005 5 Pages
Session 15: Limitation of Ratio Analysis
Learning Objective

Explain to the participants on the limitation of ratio analysis.
Important Termss

Creative accounting.
Accounting Policies.
Limitations of Ratios

Accounting Information
Different Accounting Policies
The choices of accounting policies may distort inter company comparisons. Example IAS 16 allows valuation of assets to be based on either revalued amount or at depreciated historical cost. The business may opt not to revalue its asset because by doing so the depreciation charge is going to be high and will result in lower profit.
Creative accounting
The businesses apply creative accounting in trying to show the better financial performance or position which can
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It is likely to be done in a sensitive period, perhaps when the business 's profits are low.
Changes in Accounting standard
Accounting 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 trading
As 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 best 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 selling season. This time the business will have good inventory levels, receivables and bank balances will be at its highest. While as in planting seasons the company will have a lot of liabilities through the purchase of farm inputs, low cash balances and even nil receivables.
Inter-firm comparison
Different financial and business risk profile
No 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. One company may be able to obtain bank loans at reduced rates and may show high gearing

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