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The Limitations of Financial Ratios

Profitability Ratios

The inflation of prices affects the financial ratios reported by organizations. Companies usually prepare financial reports, either quarterly, semi-annually, or annually. During these different periods, inflation might occur, leading to the distortion of prices (Rashid, 2018). Eventually, failure to reflect real prices of commodities will emerge in the reports. The calculation of profitability ratios during the period results in wrong values that mislead the interested parties. For instance, inflation leads to high ratios that misguide the management about high profits that the firm makes, which is not the case (Rashid, 2018). Hence, inflation gives wrong financial ratios in a company report unless adjusted.

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Liquidity Ratios

Seasonal factors also limit the financial ratios presented in the reports of companies (Dobosz, 2013). Seasonal factors include changes that the organization encounters during its operation. There are some periods when the company use a lot of assets for its production (Faello, 2015). During such times, liquidity ratio tends to increase beyond what it should reflect. It implies that using a high peak period results in a misrepresentation of the real ratio of the company (Rashid, 2018). Therefore, every industry need to know its variations of seasonal periods to do correct ratio representation in the reports.

Activity Ratios

Changes in the accounting method limit the financial ratios of the company. An organization may decide to change how it is valuing its inventory turnover. For instance, a company that was initially applying first-in-first out (FIFO) for inventory turnover valuation may change the estimate to last-in-first-out (LIFO) method or the Weighted Average method (Faello, 2015). Generally, shifts in the accounting method yields difficulties in comparing the new ratios with the past ratios that did apply the previous approaches (Faello, 2015). Moreover, comparing financial ratios from companies that differ accounting principles produces wrong analysis.

Leverage Ratios

Wrong calculations or misstatement of values may limit the usefulness of financial ratios. Numerators and denominators are involved in computing ratios. When either of them is not accurately stated in the calculation, the actual value is missed. Sadly, some managers manipulate the resulting ratios with errors, thus, giving false impressions about the firm (Faello, 2015). For instance, debts of the company can be underquoted by managers to show that the organization has low dependence on non-owners. Generally, firms with high leverage ratios are riskier than those relying on equity (Rashid, 2018). The implication is that, underquoting the debt make companies present good leverage positions.

Presentation to Shareholders

Reporting of the liquidity, profitability, activity, and leverage ratios are essential to the shareholders who are the owners of the company. Through the liquidity ratio, shareholders will be able to determine the ability of the firm to meet its short-term obligation (Dobosz, 2013). The profitability ratio indicates the success of managers in generating profits. The activity ratio will establish the efficiency of the firm in making a profit from its sales (Rashid, 2018). Finally, through leverage ratio, shareholders will determine how much the organization depends on debt which affects its riskiness in general.

Conclusion

Financial ratios are a critical element in the analysis of industrial performance and economic stability. Through financial ratios analysis, the company can determine its efficiency in meeting its short-term liability, profitability, leverages and how much it is using its assets to generate sales. However, financial ratios face limitations such as inflation, seasonal factors, changing accounting methods and wrong calculations, which should be corrected before making financial reports.

References

Dobosz, J. (2013). Ten ratios to make you money in stocks. Forbes. Web.

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Faello, J. (2015). Understanding the limitations of financial ratios. Academy of Accounting and Financial Studies Journal, 19(3), 75-77.

Rashid, C. A. (2018). Efficiency of financial ratios analysis for evaluating companies’ liquidity. International Journal of Social Sciences and Educational Studies, 4(4), 110. Web.

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