Answer to Question #47723 in Finance for Coleine

Question

Prepare a report to be presented by the vice-president at the board of directors’ meeting to be held in April 2011. The report must include the following:

a.An explanation of THREE (3) ways in which ratios may be used to interpret the financial statements of an organisation.

b.A caution statement containing the limitations of using ratios to evaluate the performance of an organisation

Answer 1

a. A company's ratios are used comparatively in two main fashions: over time and against other companies. Comparing the same ratios for a firm over time is a great way to identify a company's trends. If certain ratios are steadily improving, it may suggest an improvement in a company's operations or financial situation; conversely, if certain ratios seem to be getting worse, it may highlight some troubling prospects about the firm.
It's also important to compare a company's ratios against those of others in the industry. A company's ratios may be improving over time, but how do they stack up against their peers' ratios? If they aren't as rosy as those of competitors, this may indicate that the company isn't as well positioned or managed as well as other industry players.
b. There are some important limitations of financial ratios that analysts should be conscious of:
- Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios.
- Inflation may have badly distorted a company's balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment.
- Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the back-to-school season. As a result, the company's accounts payable will be high and its ROA low.
- Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.).
- It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations.
- A company may have some good and some bad ratios, making it difficult to tell if it's a good or weak company.