Inadequacies of Accounting Ratios as Tools of Financial Analysis.
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 ANALYST
In 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 EQUITY
A 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 EMPLOYED
The computation of Return On Capital Employed (ROCE) attempts to relate the net income to all sources
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 ANALYST
In 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 EQUITY
A 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 EMPLOYED
The computation of Return On Capital Employed (ROCE) attempts to relate the net income to all sources