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Limitations of Ratio Analysis Essay

The debt-equity ratio gives an indication of an enterprise’s ability to sustain losses without jeopardizing the interests of creditors. This ratio is based only on information provided in the balance sheet. Although stockholders’ equity serves as a buffer to protect the creditors’ interests, it should be kept in mind that the earning prospects of the enterprise are also relevant in judging a firm’s ability to survive the long run. Although the use of ratios can prove helpful in analyzing financial data, there are some pitfalls.

The first thing to keep in mind is that ratios based on accounting records will inherit many of the deficiencies of the accounting data. For example, ratios that incorporate long-lived assets in their calculations will be affected by the convention of recording assets at cost rather than current value and by the alternatives available for recording depreciation. Thus, two companies may be virtually identical, but the use of straight-line depreciation by one and accelerated depreciation by the other will result in differences when such things as the return on assets or the book value per share are computed.

This could be overcome by making suitable adjustments in the data to place all firms on a comparable basis, but the analyst usually lacks sufficient data for doing this. Another danger to be alert for is the arithmetic effect of certain types of transactions on the ratios. For example, the quick ratio is supposed to provide an indication of the company’s ability to meet its current obligations when due. Suppose a company has cash of $40 million, accounts payable of $30 million, and no other current assets or liabilities.

The current ratio and quick ratio would both be 1. 3 to 1. Now suppose that the company used $20 million to pay a like amount of accounts payable. This transaction should have no special significance, as both the very liquid assets and the current liabilities would be reduced by the same amount — to $20 million and $10 million, respectively. The impact on the quick ratio is significant. This ratio would now be 2 to 1. Ratios are most meaningful when viewed in comparison with those of other firms of a similar nature and when the trend of a period of years is established.

Business services such as Dun&Bradstreet and Robert Morris Associates compile lists of important ratios for many industries, and these may be used in comparing the ratios of a particular company to those of its industry. One would expect, for example, that a firm in the meat-packing industry would have a smaller income as a percentage of sales than firms in the pharmaceutical industry. Comparing the operating ratios of a meat-packing firm with those of other meat-packing firms would give more meaningful results than comparisons with averages for all manufacturing industries.

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