One of our students approached us for help in a Finance Assignment, discussion question given below –
Referencing this week’s readings and lecture, what are the limitations of financial ratios? Classify your answer into at least the following categories: liquidity ratios, activity ratios, leverage ratios, and profitability ratios.
Respond to at least two of your classmates’ posts.
In our answer to the question we explained ratio analysis and its primary objective. Then we mentioned some general limitations of the ratio analysis and then enumerated specific limitations of the six categories listed in the question.
Ratio Analysis is used in analysis of financial statements and can be used to gain an insight in to an organization’s financial performance. The technique involves calculating ratios from the data available in the financial statements. These ratios are classified in five broad categories – Short Term Solvency Ratio, Debt Management Ratios, Asset Management Ratios, Profitability Ratios and Market Value Ratios (Lane, 2017).
Though widely used ratio analysis also has its limitations. Primarily the technique uses historical data published in financial statement so results attained are for past, they may or may not be applicable for the present time. Often ratios are used to compare performance of one company with another or past performance with current performance. This comparison and subsequent interpretation may not be correct due to difference in accounting policies or due to different operational structure. Apart from this each ratio may have its own limitations.
Limitations of Liquidity Ratios
These ratios are calculated to ascertain if the company would be able to pay its short or long term debt obligation. Current Ratio is one of such liquidity ratios, it main limitation is that it includes inventory in its assessment of a company’s short term liquidity position. Inventory however may not be so easily converted into cash therefore this ratio may not be an appropriate measure of short term liquidity.
Limitations of Asset Management Ratios
These ratios help in evaluating firm’s ability in managing its assets. One such ratio is total asset turnover ratio. This ratio includes idle assets which are not included in production hence the result and its interpretation about a company’s efficiency in managing its assets may not be accurate. Additionally it does not provide information on performance on individual assets (Adams, n.d.).
Lane, M. (2017). Ratio Analysis. Zenwealth.com. Retrieved 20 March 2017, from http://www.zenwealth.com/BusinessFinanceOnline/RA/RatioAnalysis.html
Adams, D. Advantages & Disadvantages of Total Assets Turnover. Smallbusiness.chron.com. Retrieved 20 March 2017, from http://smallbusiness.chron.com/advantages-disadvantages-total-assets-turnover-10038.html