Value and limitations of financial ratios

60.2 What accounts leave out

Focus on quantitative data 

Money acts as the language of accounting, allowing business transactions to be measured, compared and added together. This means that accounts focus on items that can be given a financial value. Yet a successful business depends a lot more than the price paid for property and equipment, or the size of its outstanding debt eg. a business having good customer service, a good culture and high ethical standards. 

Using profit as a performance indicator

Profit is generally regarded as one of the most important indicators of performance. Yet the long-term success of a business may depend on a firm's willingness to sacrifice profits, in the short-term at least. It may be useful, therefore, to also consider other indicators, such as growth in revenue and market share or investment in research and development and new product success. 

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60.2 What accounts leave out

The state of the market 

The nature of accounts means that they are historical. No business can assume that the environment in which it operates will remain the same. The conditions that contributed to past performance, however recent, are bound to change at some point.

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60.3 Analysing ratios over time

Most published accounts provide data covering the most recent two years. This allows a comparison between this year and last year, which is useful. Unfortunately there are risks with such limited comparisons. 

Comparing ratios over time helps not only to get a sense of trends, but also to understand what a business is capable of. 

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60.5 Problems interpreting accounts

Although the purpose of a firm's accounts is to assign a value to the items contained within them, there are a number of reasons why such values should be treated with caution.

Recievables - A high proportion of recievables made up of bad debts will result in an overvaluation of a firm's current assets on the balance sheet, increasing the chances of liquidity problems. 

Inventories -  The value of inventories can change rapidly, especially in industries subject to frequent changes in customer tastes. The traditional accounting practice is to value stock at cost or net realisable value, whichever is the lower. This means that the value of unsellable stock is potentially zero. 

Profit quality - It's important that a firm's account seperte 'one-off' low-quality profit from the high-quality profit that results from its normal trading activities.

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60.6 Manipulating the published accounts

There's a number of reasons why a business may decide to manipulate its accounts in order to flatter its financial position at a particular point in time - window dressing. This can create the account the impression that a businesses is financially stronger than it actually is. This can help to secure loans or support the sale of new shares. Common methods of window dressing include the following.

Sale and leaseback of fixed assets - disguises a a poor or deteriorating liquidity problem by generating a sudden injection of cash. 

Bringing forward sales - a sale is made when an order is made, rather than when payment is recieved. Encouraging customers to place orders earlier than usual will mean that they are included at the end of one financial period rather than at the start of the next, giving an apparent boost to revenue and profit.

The Companies Act 2006 places a legal obligatoin on companies to provide accounts that are audited and give a true and fair view of their financial position. 

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60.7 Strengths and weaknesses of ratio analysis

Strengths 

  • Used widely by financial analysts and journalists, by trade unions (to negotiate pay etc) and by managers themselves.
  • Focusing on specific areas of the accounts makes comparisons much quicker and easier to do.
  • Most users of acoutns are interested in what rather than why; for instance they want to know what the gearing level is rather than why it's at that level; ratios give this info with speed. 
  • Managements can gain insight from their rivals' performance as shown by ratios.

Weaknesses

  • Is to take the figures from ratio analysis as facts; the reality is that they are more like averages which can be deceiving. 
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