Original Question: Referencing this weeks readings and lecture, what are the limitations of financial ratios? Classify your answer into at least the following categories: liquidity ratios, activity ratios, leverage ratios, and profitability ratios.
Response 1: Half Page – Tisha ,
According to Epstein (2014), financial ratios are used to recognize trends within a companys financial results (ch. 6). Reviewing the financial results in this manner provides a more accurate representation of the companys financial health. However, measuring the companys liquidity, activity, leverage, and profitability have its limitations. The limitations in determining the companys financial health include the companys structure, inflation, seasonality, and various accounting methods.
The companys structure is one element that plays a crucial part when comparing companies within the same industry. Take, for example, company A. The company operates in two distinct industries: telecommunications and automotive. Determining which industry financial standards to base its viability creates limitations. If managers compare metrics within the telecommunications industry, it isolates the automotive metrics and vice versa.
Time parameters also play a part in limitations placed on comparing financial ratios. Measuring financial effectiveness year over year or multiple years can be precarious due to economic trends. Inflation plays a significant role and needs to be taken into consideration when reporting annually over multiple years. Specific industries, such as retail or manufacturing, encounter seasonality limitations. As such, quarterly comparisons should not necessarily be used when likening companies as they may have peak seasons and slow seasons.
The last barrier when reviewing financial ratios includes accounting methods being used by competitors. Each company can use different ways to report finances and may not be comparable. For example, a company that provides a service, training, and installation may report the cash inflow differently than another company.
Overall, there are limitations that financial managers and investors need to consider when reviewing a companys financial health. A careful review of the notes section within the annual report will provide additional details to compare similar items.
Response 2 Half Page – Michael,
The way a company is set up may have an affect on how ratios are interpreted. Some organizations such as Ford Motor Company, have more than one business division. In the case of Ford, they have the automotive division and financial division (CSIMarket.com, 2021). These organizations are called conglomerates. When an organization operates multiple business lines it is difficult to determine which ratios to use and who is considered a market competitor (Epstein, 2014). Other limitations affect the effectiveness of ratios:
Inflation
Seasonality
Accounting methods
Fixed Assets at Cost
Projections about Future Trends
Liquidity ratios are used to determine the quality of current assets and if they meet current obligations. Liquidity is affected by cash flows that are erratic. Companies such as airlines and retail stores are examples of organizations with erratic cash flows. Airlines sales tend to fluctuate during holidays and retail stores are impacted during holidays, season changes, and back to school.
Activity ratios measure how well an organization manages its assets and liabilities. Activity ratios consists of four turnover ratios: accounts receivable, inventory, total assets, and accounts payable. The turnover ratios measure days it will take to collect assets, sell on-hand inventory, and pay liabilities. The accounts receivable turnover ratio is limited due to it being a 12-month report. It does not factor for seasonal sales. The ratio can be monitored closer if the reports are developed more frequent. Inventory turnover is limited by the fact that some inventory may be sold faster than other.
Leverage ratios are measure how much debt the company owes and if it can pay the debt on its long-term obligations. There are five leverage ratios: debt to equity, interest coverage, debt to capital, cash debt coverage, and cash flow coverage. By increasing the debt-to-equity ratio, the investors return on capital increases. Companies can manipulate the figures to show they have more equity than debt.
Profitability ratios are simply used to determine if a business is profitable. There are six ratios used to determine profitability: price/earnings, net profit, cash flow margin, dividend yield, return on assets, and return on equity. The limitations of this ratio is based on how the company raises or pays cash. If stocks or bonds are sold to raise cash, and then bought back, it will show cash in and out. If an organization sells property or equipment during a period, it will affect the ratio. If these actions are not forecasted, the ratio will usually not project what was expected.
