USES AND LIMITATIONS OF RATIO ANALYSIS

As illustrious previous, ratio analysis is worn by three main groups: (1) managers, who employ ratios to help evaluate, control, and thus recover their firms' operations; (2) credit analysts, such as bank loan officers or attachment rating analysts, who analyze ratios to help determine a company's aptitude to pay its debts; and (3) stock analysts, who are involved in a company's efficiency and enlargement prediction.

While ratio analysis can supply useful in sequence relating to a company's operations and financial condition, it does have confines that require watchfulness and judgment. Some possible problems are:

1. Many large firms activate various divisions in various industries, and this makes it intricate to expand a meaningful set of industry averages for relative purpose. Therefore, ratio analysis is more useful for minute, barely focused firms than for huge, multidivisional ones.

2. Most firm want to be better than standard, so merely attaining average presentation is not unavoidably good. As a target for high-level presentation, it is best to focus on the manufacturing leaders' ratios.

3. Increase may have deficiently indistinct firms' balance sheets-record values are often considerably various from "true" values. Further, since inflation affect both decrease charge and account costs, profits are also affected. Thus, a ratio analysis for one firm over time, or a relative analysis of firms of various ages, must be interpreted with judgment.

4. Regular factor can also disfigure a ratio analysis. For example, the record turnover ratio for a toy company will be completely dissimilar if the balance sheet numeral used for supply is the one just previous to versus just after the close of the Christmas season. Using journal averages for catalog (and receivables) when calculating ratios such as turnover can decrease this problem.

5. Firms can employ technique to make their financial statements look stronger. As an example, a company might make use of on a two-year basis on December 28, 2002, hold the earnings of the loan as cash for a few days; and then pay off the loan on January 2, 2003. This inexpensively meaningless operation improved the firm's current and speedy ratios and made the year-end 2002 balance sheet look superior. However, the improvement was stringently provisional. One week later the balance sheet was back at the old level.

6. Different accounting practice can distort comparison.  As noted previous, register assessment and reduction methods can affect financial statements and thus distort comparisons among firms. If one firm leases a substantial amount of its industrious equipment, then its assets may emerge low relative to sales because leased assets often do not appear on the balance sheet. At the same time, the lease legal responsibility may not be shown as a debt. Therefore, leasing can unnaturally improve both the turnover and the debt ratios.

7. It is difficult to simplify about whether a meticulous ratio is "high-quality" or "terrible." For example, a high current ratio may indicate a strong liquidity position, which is high quality or excessive cash, which is terrible (because excess cash in the bank is a nonearning asset). Similarly, a high fixed assets turnover ratio may indicate either a firm that uses its possessions professionally or one that is undercapitalized and cannot have enough money to buy enough assets.

8. A firm may have a quantity of ratios that look "good" and others that look "bad," making it hard to tell whether the organization is, on balance, strong or weak. However, statistical events can be used to analyze the net belongings of a set of ratios. Many banks and other lending company use arithmetical measures to analyze firms' financial ratios, and, on the basis of their analyses, classify companies according to their prospect of getting into financial trouble.

Ratio analysis is functional, but analysts should be aware of these problems and make essential adjustments. Ratio analysis conduct in a mechanical, unthinking manner is deceptive, but used brightly and with good decision, it can supply useful insight into a firm's operations.