Ratio Analysis: Setbacks Ratio Analysis: Potential Pitfalls

In basic terms, ratio analysis comes in handy in the evaluation of a firm's current financial position and the direction this position is expected to take in the future" (Besley and Brigham, 2008, p. 250). That ratio analysis is a critical tool when it comes to the analysis of an entity's performance is not an overstatement. As a matter of fact, most investors rely on ratio analysis in the analysis of the financial statements of various companies so as to determine the most appropriate entity in which to invest.

Here are some ratios for my week six company, i.e. Caterpillar -- for the year ended Dec 31st 2013.

Liquidity ratio

Current ratio = current assets/current liabilities = 38,335,000/27,297,000 = 1.40

Profitability ratio

Return on equity = Net Income/shareholder equity = 3,789,000/20,811,000 = 0.18

Efficiency ratio

Receivables turnover = Annual credit sales/accounts receivable = 55,656,000/18,729,000 = 2.97

It should be noted that although useful, ratio analysis has its own setbacks. In that regard, therefore, it is not all that is needed to make an informed decision regarding the financial health of a given entity....

To begin with, ratios are only relevant when utilized in a comparative context (Lee, 2007). This is to say that when one has access to only a single year's worth or an entity's financial statements, financial ratios may not be useful. The ratios computed above do not tell us much about the financial viability and health of Caterpillar Company. Ratios of a given entity may also not be useful unless they are compared to the financial ratios of another entity. It would be futile to, for instance, compute the ratios above and make use of them to come up with a decision on whether or not to invest in Caterpillar without comparing them with those of another company in the same industry as Caterpillar, i.e. A competitor. In simple terms, therefore, without a reference point, financial ratios may not be as useful. Next, it is also important to note that as Lee (2007, p. 250) points out, due to the fact that they are founded on the accounting numbers that are reported on the financial statements of entities, "they contain all the accounting limitations of these numbers including the flexibility and subjectivity of GAAP, the possible presence of creative accounting practices, and the inherent limitations of historical cost account." This effectively means that they could absorb the effects of accounting…