Limitation of Ratio Evaluation

Learning Objective

  • Show the individuals on the limitation of ratio research.

Important Terms

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  • Creative accounting.
  • Accounting Plans.

As we have alredy discussed, it’s important to compare to become in a position to analyse and have the ability to comment and consequently recommend to ensure that a business is really as efficient as you possibly can.

Limitations of Ratios

    1. Accounting Information
  • Different Accounting Policies

    The choices of accounting policies may distort inter company comparisons. Example IAS 16 allows valuation of possessions to be based on either revalued amount or at depreciated historical cost. The business may opt not to revalue its property because by doing so the depreciation fee is likely to be high and can result in lower revenue.

  • Creative accounting

    The businesses apply creative accounting in trying showing the better financial performance or position which may be misleading to the users of financial accounting. Like the IAS 16 mentioned previously, requires that if a secured asset is revalued and there is a revaluation deficit, it has to be charged as an expense in income declaration, but if it results revaluation surplus the surplus should be acknowledged to revaluation reserve. So in order to boost on its profitability level the company may select in its revaluation programme to revalue only those belongings which will result in revaluation surplus giving those with revaluation deficits still at depreciated historical cost.

  • Information problems
    • Ratios aren’t definitive measures

      Ratios need to be interpreted carefully. They can offer clues to the company’s performance or financial situation. But independently, they cannot show whether performance is good or bad.

      Ratios require some quantitative information for the best analysis to be made.

    • Outdated information in financial statement

      The information in a set of accounts are likely to be at least almost a year outdated, and so might not provide a proper indication of the company’s current financial position.

    • Historical costs not ideal for decision making

      IASB Conceptual construction recommends businesses to utilize historical cost of accounting. Where historical cost convention is used, asset valuations in the total amount sheet could be misleading. Ratios based on this information will never be very useful for decision making.

    • Financial claims certain summarised information

      Ratios derive from financial statements which can be summaries of the accounting data. With 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 time end information which may well not be considered a true representation of the entire year’s results.

    • Interpretation of the ratio

      It is difficult to generalise about whether a specific ratio is ‘good’ or ‘bad’. For instance a higher current ratio may reveal a strong liquidity position, which is good or increased cash which is bad. In the same way Non current belongings turnover ratio may denote the organization that uses its possessions efficiently or one which is under capitalised and cannot manage to buy enough resources.

  • Comparison of performance as time passes
    • Price changes

      Inflation renders comparisons of results over time misleading as financial results will not be within the same degrees of purchasing ability. Changes in results over time may show as if the business has improved its performance and position when in simple fact after changing for inflationary changes it will show different picture.

    • Technology changes

      When evaluating performance as time passes, there may be need to consider the changes in technology. The activity in performance should be in lines with the changes in technology. For ratios to be more meaningful the venture should compare its results with another of the same degree of technology as this will be a good basis measurement of efficiency.

    • Changes in Accounting policy

      Changes in accounting plan may affect the assessment of results between different accounting years as misleading. The challenge with this situation would be that the directors might be able to change the results through the changes in accounting policy. This would be done to avoid the effects of an old accounting insurance policy or gain the effects of a new one. It is likely to be achieved in a sensitive period, perhaps when their revenue are low.

    • Changes in Accounting standard

      Accounting specifications offers standard means of recognising, calculating and showing financial deals. Any change in specifications will influence the reporting of the enterprise and its assessment of results over quite a few years.

    • Impact of months on trading

      As explained above, the financial statements are based on year end results which may not be true representation of results all year round. Businesses that are affected by conditions can choose the best time to create financial statements so as to show better results. For instance, a tobacco growing company can show great results if accounts are produced in the offering season. This time around the business will have good inventory levels, receivables and bank or investment company amounts will be at its highest. While just as planting seasons the business will have a great deal of liabilities through the purchase of farm inputs, low cash amounts and even nil receivables.

  • Inter-firm comparability
    • Different financial and business risk profile

      No two companies are the same, even though they are competition 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 loans at reduced rates and could show high gearing levels while as another may not be successful in obtaining cheap rates and it may show that it’s functioning at low gearing level. To un educated analyst he may feel just like company two is better when in simple fact its low gearing level is basically because it can not be in a position to secure further financing.

    • Different capital buildings and size

      Companies may have different capital set ups and to make evaluation of performance when is all equity financed and another is a geared company it might not be a good analysis.

    • Impact of Government influence

      Selective software of government incentives to various companies may also distort intercompany contrast. One company may get a tax holiday while the other within the same line of business not, looking at the performance of the two businesses may be misleading.

    • Home window dressing

      These are techniques applied by an entity in order to show a strong financial position. For instance, MZ Trucking can borrow against a two time basis, K10 Million on 28th December 2003, retaining the proceeds as cash, then pay off the loan in advance on 3rd January 2004. This may enhance the current and quick ratios and make the 2003 balance sheet look good. Nevertheless the improvement was purely screen dressing as a week later the total amount sheet is at its old position.

    Ratio analysis pays to, but analysts should become aware of these problems and make alterations as necessary. Ratios evaluation conducted in a mechanical, unthinking manner is dangerous, but if used intelligently and with good judgement, it can provide useful insights into the firm’s procedures.