Uses and Limitations of Ratio Analysis

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1 Uses and Limitations of Ratio Analysis Balkrishna Parab ACS, AICWA F inancial statement analysis involves comparing the firm s performance with that of other firms in the same industry and evaluating trends in the firm s financial position over time. These studies help management identify deficiencies and then take actions to improve performance. One of the ways in which financial statements can be put to work is through ratio analysis. Ratios are simply one number divided by another; as such they may or not be meaningful. In finance, ratios are usually two financial statement items that may be related to one another and may provide the prudent user a good deal of information. Financial analysis is as much an art as it is a science. Combine any two figures from an annual report and a ratio is produced; the real skill is in deciding which figures to use, where to find them and how to judge the result. Generally ratios are divided into four areas of classification that provide different kinds of information: liquidity, turnover, profitability and debt. Liquidity ratios indicate the firmʹs ability to meet it maturing shortterm obligations. Balkrishna Parab is a member of the core faculty at the Jamanalal Bajaj Institute of Management Studies, University of Mumbai, 164, H. T. Parikh Marg, Backbay Reclamation, Mumbai Contact details: Telephone (O) , , (C) <balkrishnaparab@jbims.edu>.

2 Turnover indicates how effectively the firm manages resources at its disposal to generate sales. Profitability indicates the efficiency with which manages resources. Debt indicates the extent to which the firm is financed by debt. Effective ratio analysis involves relating the financial numbers to the underlying business factors in as much detail as possible. While ratio analysis may not give all the answers to an analyst regarding the firm s performance, it will help the analyst frame questions for further probing. In ratio analysis, the analyst can Compare ratios for a firm over several years Compare ratios for the firm and other firms in the industry Compare ratios to some absolute benchmark. Users of Ratio Analysis Ratio analysis is used by the various groups of people, such as managers, credit analysts, stock analysts, business analysts, shareholders, lenders, customers, competitors, etc., Managers, who employ ratios to help analyze, control, and thus improve their firms operations. Management and other employees are usually most interested in the profit being generated from their section of the business and in assessing their employment prospects. Senior executives are expected to focus on the overall levels of profitability being provided by the company s main operating units, its strategic business units (SBUs). Their interest should be focused on the future potential rather than the historic performance of the company. Credit analysts, including bank loan officers and bond rating analysts, who analyze ratios to help ascertain a company s ability to pay its debts; and Stock analysts, who are interested in a company s efficiency, risk, and growth prospects. Business analysts may be expected by their clients or employers to provide an indication of whether a particular company s shares are worth holding or buying for future balkrishnaparab@jbims.edu 2

3 gain, or are best sold immediately. They will study the current year s profit and compare it with previous years and that of other companies, and set this against their assessment for the future of the business sector to forecast profit trends. Shareholders may be most concerned about the ability of a company to maintain or improve the value of their investment and future income stream. They look to the company to generate sufficient profit to provide for dividend payments and an increase in the market value of the shares they own. Lenders of money may be expected to be most interested in evidence to support the company s ability to continue to pay the interest on borrowed funds as this falls due. Customers may be concerned to assess the levels of profit being made, particularly if there is regulation of the business sector intended to offer some level of customer protection. Now that increasing emphasis is put on high standards of customer service and satisfaction, there is little advantage in making excessive short-term profits at the long-term expense of the customer. Competitors are most interested in comparing their own performance and efficiency with that of other companies operating in the same business sector. Limitations of Ratio Analysis We have all heard stories of whizzes who can take a company s accounts apart in minutes, calculate a few financial ratios, and discover the company s innermost secrets. The truth, however, is that financial ratios are no substitute for a crystal ball. They are just a convenient way to summarize large quantities of financial data and to compare firms performance. Ratios help you to ask the right questions: they seldom answer them. While ratio analysis can provide useful information concerning a company s operations and financial condition, it does have limitations that necessitate care and judgment. Some potential problems are listed below: balkrishnaparab@jbims.edu 3

4 Multi-Product Companies Many large firms operate different divisions in different industries, and for such companies it is difficult to develop a meaningful set of industry averages. Therefore, ratio analysis is more useful for small, narrowly focused firms than for large, multidivisional ones. Different Accounting Policies The choices of accounting policies may distort inter-company comparisons. For example, accounting standards 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 be misleading to the users of financial accounting. For example, accounting standards, require that if an asset is revalued and there is a revaluation deficit, it has to be charged as an expense in income statement, but if it results in revaluation surplus the surplus should be credited to revaluation reserve. So in order to improve on its profitability level the company may select in its revaluation programme to revalue only those assets which will result in revaluation surplus leaving those with revaluation deficits still at depreciated historical cost. Window Dressing These are techniques applied by an entity in order to show a strong financial position. Firms can employ window dressing techniques to make their financial statements look stronger. Window dressing techniques are techniques employed by firms to make their financial statements look better than they really are. To illustrate, a Mumbai-based builder borrowed on a two-year basis on March 29, 2001, held the proceeds of the loan as cash for a few days, and then paid off the loan ahead of time on April 2, This improved his current and quick ratios, and made his year-end 2001 balance sheet look good. However, the improvement was strictly window dressing; a week later the balance sheet was back at the old level. Ratios are not Definitive Measures Ratios need to be interpreted carefully. They can provide clues to the company s performance or financial situation. But on their own, they balkrishnaparab@jbims.edu 4

5 cannot show whether performance is good or bad. Ratios require some quantitative information for an informed analysis to be made. Outdated Information in Financial Statement The figures in a set of accounts are likely to be at least several months out of date, and so might not give a proper indication of the company s current financial position. Financial Statements Contain Summarised Information Ratios are based on financial statements which are summaries of the accounting records. Through the summarisation some important information may be left out which could have been of relevance to the users of accounts. The ratios are based on the summarised year end information which may not be a true reflection of the overall year s results. Inflation The financial accounting conceptual framework recommends businesses to use historical cost of accounting. Where historical cost convention is used, asset valuations in the balance sheet could be misleading. Ratios based on this information will not be very useful for decision making. Inflation may have badly distorted firms balance sheets recorded values are often substantially different from true values. Further, since inflation affects both depreciation charges and inventory costs, profits are also affected. Thus, a ratio analysis for one firm over time, or a comparative analysis of firms of different ages, must be interpreted with judgment. Price Changes Changes in the price levels renders comparisons of results over time misleading as financial figures will not be within the same levels of purchasing power. Changes in results over time may show as if the enterprise has improved its performance and position when in fact after adjusting for inflationary changes it will show the different picture. Technology Changes When comparing performance over time, there is need to consider the changes in technology. The movement in performance should be in line with the changes in technology. For ratios to be more meaningful the enterprise should compare its results with another of the same level of technology as this will be a good basis measurement of efficiency. balkrishnaparab@jbims.edu 5

6 Changes in Accounting Policy Changes in accounting policy may affect the comparison of results between different accounting years as misleading. The problem with this situation is that the directors may be able to manipulate the results through the changes in accounting policy. This would be done to avoid the effects of an old accounting policy or gain the effects of a new one. It is likely to be done in a sensitive period, perhaps when the business s profits are low. Seasonal Factors 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. Seasonal factors can also distort a ratio analysis. For example, the inventory turnover ratio for a food processor will be radically different if the balance sheet figure used for inventory is the one just before versus just after the close of the canning season. This problem can be minimized by using monthly averages for inventory (and receivables) when calculating turnover ratios. Differences in Accounting Practices Different accounting practices can distort comparisons. As noted earlier, inventory valuation and depreciation methods can affect financial statements and thus distort comparisons among firms. Also, if one firm leases a substantial amount of its productive equipment, then its assets may appear low relative to sales because leased assets often do not appear on the balance sheet. At the same time, the liability associated with the lease obligation may not be shown as a debt. Therefore, leasing can artificially improve both the turnover and the debt ratios. However, the accounting profession has taken steps to reduce this problem. Difficult to Interpret It is difficult to generalize about whether a particular ratio is good or bad. For example, a high current ratio may indicate a strong liquidity position, which is good, or excessive cash, which is bad (because excess cash in the bank is a nonearning asset). Similarly, a high fixed assets balkrishnaparab@jbims.edu 6

7 turnover ratio may denote either a firm that uses its assets efficiently or one that is undercapitalized and cannot afford to buy enough assets. Difficult to Make Overall Assessment A firm may have some ratios that look good and others that look bad, making it difficult to tell whether the company is, on balance, strong or weak. However, statistical procedures can be used to analyze the net effects of a set of ratios. Many banks and other lending organizations use such procedures to analyze firms financial ratios, and then to classify them according to their probability of getting into financial trouble. 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 levels while as another may not be successful in obtaining cheap rates and it may show that it is operating at low gearing level. To uninformed analyst he may feel like company two is better when in fact its low gearing level is because it can not be able to secure further funding. Different Capital Structures and Size Companies may have different capital structures and to make comparison of performance when one is all equity financed and another is a geared company it may not be a good analysis. Impact of Government Influence Selective application of government incentives to various companies may also distort inter-company comparison. One company may be given a tax holiday while the other within the same line of business not, comparing the performance of these two enterprises may be misleading. balkrishnaparab@jbims.edu 7

8 Looking Beyond the Numbers Sound financial analysis involves more than just calculating numbers good analysis requires that certain qualitative factors be considered when evaluating a company. These factors, as summarized below: Bargaining Power of Buyers Are the company s revenues tied to one key customer? If so, the company s performance may decline dramatically if the customer goes elsewhere. On the other hand, if the relationship is firmly entrenched, this might actually stabilize sales. Dependence on One Product To what extent are the company s revenues tied to one key product? Companies that rely on a single product may be more efficient and focused, but a lack of diversification increases risk. If revenues come from several different products, the overall bottom line will be less affected by a drop in the demand for any one product. Bargaining Power of Suppliers To what extent does the company rely on a single supplier? Depending on a single supplier may lead to unanticipated shortages and thus to lower profits. Dependence on Foreign Markets What percentage of the company s business is generated overseas? Companies with a large percentage of overseas business are often able to realize higher growth and larger profit margins. However, firms with large overseas operations also find that the value of their operations depends in large part on the value of the local currency. Thus, fluctuations in currency markets create additional risks for firms with large overseas operations. In addition, the political stability of the region is important. Competition Generally, increased competition lowers prices and profit margins. In forecasting future performance, it is important to assess both the likely actions of the current competition and the likelihood of new competitors in the future. Future Prospects Does the company invest heavily in research and development? If so, its future prospects may depend critically on the success of new products in balkrishnaparab@jbims.edu 8

9 the pipeline. For example, the market s assessment of a computer company depends on how next year s products are shaping up. Likewise, investors in pharmaceutical companies are interested in knowing whether the company has developed any potential blockbuster drugs that are doing well in the required tests. Legal and Regulatory Environment Changes in laws and regulations have important implications for many industries. For example, when forecasting the future of tobacco companies, it is crucial to factor in the effects of proposed regulations and pending or likely lawsuits. Likewise, when assessing banks, telecommunications firms, and electric utilities, analysts need to forecast both the extent to which these industries will be regulated in the years ahead, and the ability of individual firms to respond to changes in regulation. balkrishnaparab@jbims.edu 9