Inadequacies Of Accounting Ratios As Tools Of Financial Analysis.

1480 words - 6 pages

Ratio analysis provides an indication of a company's liquidity, gearing and solvency. But ratios do not provide answers; they are merely a guide for management and others to the areas of a company's weaknesses and strengths (Palat 1999).However, ratio analysis is difficult and there are many limitations. This section will identify and discuss the inadequacies of accounting ratios as tools of financial analysis.ACCOUNTING POLICIES.It is difficult to use ratios to compare companies, because they very often follow different accounting policies. For example, one company may value stock under the LIFO principle, another may follow the FIFO principle. Similarly, one company may depreciate assets under the straight line method, while its competitors may be using reducing balance method. Also, one company may value their assets using the historical cost rule while another may use the alternative accounting rule. Other areas in which policies may differ between companies include development cost deferral policy, capitalisation of interest costs, etc.SKILL OF ANALYSTIn other to state whether a ratio is good or bad it must be intelligently interpreted. For example, a high current ratio may indicate, on the one hand, a liquidity position (which is positive) and, on the other excessive liquid cash (which is negative).RETURN ON EQUITYA direct comparison between the Return On Equity (ROE) of different firms may not always be meaningful. Apart from national or industrial differences in the accounting or business practices the risk of firms may well differ. For example, a firm with high gearing would be expected to earn a higher ROE than would a firm with low gearing. This would be expected to earn a higher ROE than would a firm with low gearing. This will be compensated for by a higher risk but this is not incorporated in the ROE measure.RETURN ON CAPITAL EMPLOYEDThe computation of Return On Capital Employed (ROCE) attempts to relate the net income to all sources of capital to the total value of capital contributions. Thus the income is taken before interest, minority interest, etc., and the capital includes equity, minority interest and all sources of interest-bearing debt, be they short or long term. It may be difficult to identify all the debt on the balance sheet and some analysts treat some provisions as part of equity. However, if these provisions are genuine estimates of forthcoming tax and pension liabilities they should be excluded from equity.It could be argued that the income from associated companies and other income should be included, and miscellaneous creditors and provision may well include elements of capital. Some analysts insist on adding back provisions as they view this as an accounting allocation of equity for which a liability is unlikely even to appear (Walsh 1996).LIQUIDITY MEASURESAs with all other groupings of ratios a number of alternative measures may be used which either alter the focus of the analysis, marginally alter the...

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