Accounting ratios and financial analysis methods

Accounting Ratios

The financial statements of a business entail significant financial information for people external to the business that does not have the reach to the internal accounts. To illustrate the present and prospective shareholders can visualize how much gain a business attained, the total worth of the assets and the level of cash reserves. Irrespective of the fact that such figures have utility they do not imply that with so much emphasis. (A brief insight into accounting ratios) The basic objective of all financial analysis is to find out the influence of the financial aspects on a business, basing on the present, earlier and prospective future managerial business decisions. As all the facets of a business are interconnected, it is quite essential that more correct quantification are to be made of its financial operations to indicate the later phases of activity so as to make the best feasible and viable financial conclusions. (Financial Ratios and Industry Averages)

So as to derive some real conclusion from the data in the final accounts are analyzed applying accounting ratios and then compared with either the ratio of the earlier years or against averages for the industry. Most of the companies have fixed goals in terms of ratios internally so that all their operations are anticipated to be adhered to. In this manner they make it certain that their overall operation caters to the performance objectives when the company informs to the shareholders. Then only the shareholders are satisfied with the activities of the company. (Accounting and decision making - Ratio analysis) But the accounting ratios have their own disadvantages which are also discussed in the paper.

Discussion:

The comparative information is crucial for any significant ratio analysis. But in absence of any information on either the industry averages or with the performance of the earlier years seriously delimits the analysis. Accounting ratios are dependent upon the profit and loss accounts and balance sheets those are subject to the limitations of traditional cost accounting, Inflation, distinguished bases for costing the assets or particular price variations that can twist inter- company evaluation and evaluations over a fixed duration. The ratio analysis assists in building a picture of the company, the enrichment of the picture relies on the quality of the financial information on that the ratios are based. While the ratio are weakly created, to illustrate bases on the poor estimates of depreciation, bad debts etc., and then the derivations drawn from the accounting ratios will be defective. The earlier performance of the company is not necessarily the best indicator of its prospective performance. Rather, by the time accounts are presented and available for analysis they may further be six months older. (A brief insight into accounting ratios)

One significant exception of accounting ratios is that they depend too heavily on the conventional costs that lead to twists in quantifying performance. Being not succeeded in effectively incorporating the price variation information, many think that the inaccurate evaluation of the financial conditions of the enterprise and performance result. (Basic Financial Statement Analysis: Objective 3: Explain the limitations of ratio analysis) Ratios are required to be represented meticulously. They can entail the evidences to the performance of the company or financial environment. However, they are unable to demonstrate whether the performance is good or bad out their own. The data in a group of accounts are evidentially older for a several months and therefore, may not require a proper indication of the present financial position of the company. The IASB Conceptual Framework prescribes businesses to utilize historical cost of accounting. Where the traditional cost convention is applied, the asset valuations in the balance sheet are becomes misleading.

Ratios necessitate some quantitative information for an informed analysis to be made. Ratios are dependent upon the financial statements those are summaries of the accounting records. The process of abstracting involves some significant information to be left out that could have been of much significance to the users of accounts. The ratios depend upon the abstract year end information that may not be a true reflection of the overall results of the year. It is problematic to take a broad view whether a specific ratio is good or bad. To illustrate a high present ratio may imply a strong liquidity position that is good or excessive cash that is bad. Likewise, non-current assets turnover ratio may indicate either a firm that utilizes its assets optimally or one that is under capitalized and cannot afford to purchase sufficient assets. (Session 15: Limitation of Ratio Analysis)

Inflation depicts evaluation of consequences over time misleading as financial figures will not be within the same levels of purchasing power. Variation in consequences over the period of time may depict as if the enterprise has developed its performance however, taking into account the inflationary pressure it reveals a different picture. While evaluating the performance over a fixed duration there is necessity to take into account the variations in technology. The transition in performance is required to be in line with the variations in technology. For ratios to be more apparent the enterprise is required to evaluate its consequences with another of the same level of technology as this is considered to be a good basis of quantifying the effectiveness. The variations in accounting policy may influence the evaluation of the results between different accounting years as misleading.

The difficulties with such circumstances are that the directors may not be able to regulate the consequences through the variations in accounting policy. This would be performed to eliminate the influence of an old accounting policy or gain the influence of a new one. It is prone to be performed in a sensitive period most probably when the profit of the business is low. The accounting paradigms extend the general modes of acknowledging and quantifying and presenting the financial transactions. Any variation in the standards will influence the reporting of an enterprise and its evaluation of consequences over a number of years. As indicated above the financial statements are dependent upon year end consequences that may not be the real representation of the overall year. (Session 15: Limitation of Ratio Analysis)

Thus some particular account balances those are utilized to estimate ratios may enhance or decrease at the end of the accounting period due to seasonal factors. Such variations may twist the value of the ratio. (Covers Information from Accounting 200 and 201) The businesses which are periodically influenced during a year can elect the appropriate time to generate the financial statements so as to depict better results. To illustrate, a tobacco growing company will be capable of demonstrating good performance if accounts are generated only in the marketing period. During this period the business will have good inventory levels, receivables and bank balances that are at its optimum. But during the planting periods when the company is required to have a plethora of liabilities through the purchase of farm inputs, it depicts low cash balances and even nil receivables. (Session 15: Limitation of Ratio Analysis) Thus when the operations of a seasonal business are studied, ratios may not entail an accurate quantification of the financial performance. The accounting ratios only points out the linkage between two sets of data. Additionally, one ratio cannot be taken to indicate the whole of the business. Accounting ratio analysis permits to evaluate the present performance in relation to the earlier one of the company but does not put forth any indication of the future performance. (Understanding financial analysis techniques)

A markedly low accounts ratio may give rise to angry suppliers and remarkably high inventory turnover ratios may lead to supply shortages and angry customers. The one that is correct for one company may not be considered appropriate for another one. (The Dynamic Current Ratio) Besides, no two companies are found to be similar irrespective of the fact that they are competitors in the same industry or market. Application of ratios to evaluate one company with another provides misleading information. Businesses may be within the same industry but have distinguished financial and business risk. (Session 15: Limitation of Ratio Analysis) Ratios are completely dependent on the data that may or may not be accurate. Variations in the price level of the base year and present year may not be similar hence the comparison also will be different. (Model Question Paper-1 Accountancy CBSE -- XII) The widely accepted criticism of the ratio analysis lies in the difficult problem of attaining comparability among firms in a given industry. (Basic Financial Statement Analysis: Objective 3: Explain the limitations of ratio analysis) While the outcomes in respect of the two firms are compared, it is to be remembered that the firms may adopt different accounting strategies, to illustrate; one firm may deduct depreciation on the proportionate basis and other on the declining worth. Such distinctions will not make some of the accounting ratios rigidly comparable. (Model Question Paper-1 Accountancy CBSE -- XII)

One company may be capable of attaining bank loans a the declined rates and may depict high gearing levels while as another may not be effective in attaining cheaper rates and it may show that it is operating at low encouraging levels. An unaware analyst may think the second company to be better but in reality its low encouraging level is due to the fact that it is unable to secure additional funding. The companies may possess different capital structures and to attempt comparison of performance when one is all equity financed and another is a geared company may not suffice for a good analysis. The chosen application of government incentives to several companies may also twist the inter-company evaluation. There may be the possibility of providing a company with the tax holiday while the other within the same line of business not, and evaluation of such two enterprises may be misleading. (Session 15: Limitation of Ratio Analysis)