Inadequacies of accounting ratios as tools of financial analysis - Essay Example

The multi-discriminant analysis and methodologies involving ratio disaggregation or decomposition such as DuPont analysis are commonly used as well for the purpose of financial analysis. Any user of financial statements must comprehend the limitations associated with ratio analysis. Ratios are attractive as they are simple and convenient. The ratios can only be as relevant as the data upon which they are based and the information with which they are compared. One glaring limitation of ratios is that they are based on historical cost convention, which can lead to limitations in measuring performance.

By not incorporating information on changes in price, inaccurate assessments of the enterprise's financial condition and performance result. Also, all users must keep in mind that where estimated items (such as depreciation and amortization) are large and significant, income ratios lose some of their credibility. Income recognized before the end of the life of the business is just an approximation. In analyzing the income statement, the user should be aware of the various assumptions used in the computation of net income.

As one writer aptly noted, "The physicist has long since conceded that the location of an electron is best expressed by a probability curve. Surely an abstraction like earnings per share is even more subject to the rules of probability and risk." (Cheney, 1971) Probably the greatest pitfall of ratio analysis is the difficult problem in achieving comparability of firms in a given industry. Achieving comparability among firms requires that the ratio analysis (1) identifies the basic differences existing in their accounting principles and procedures and be (2) flexible enough to adjust the balances (modify the raw data) to achieve comparability.

In any peers group ratio analysis it is important to compare ratios to the industry average ratios to see how one company compares to its competitors or even to compare with similar companies or within industries. In US one often uses Standard Industrial Classification (SIC) or North American Industry Classification System (NAICS) codes as part of peer ratio analysis. Majors like Dun and Bradstreet provides "average" ratio levels for firms in a number of different industries. Deviation from the "industry norm" by a firm may indicate one of the following: 1) a strength in the firm, 2) a weakness in the firm, or 3) a difference in the operating characteristics between the firm and the "industry norm.

" One must realize that a ratio that is higher than the norm is not necessarily better. This is obviously true for the debt-equity ratio and perhaps less obviously true for the current ratio. A current ratio that is too low may indicate that the firm is not able to raise cash easily; a current ratio that is too high may indicate that the firm is not investing its funds in the most profitable assets (fixed asset investment is often more