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Limitations of Ratio Analysis Although ratio analysis provides useful information pertaining to the efficiency of operations and the

stability of financial condition, it has inherent limitations. 1. A ratio by itself is not significant. It must be interpreted in comparison with prior ratios, predetermined benchmarks, or ratios of competitors. 2. The ability to make use of ratios is dependent upon the analysts ability to adjust the reported numbers before calculating the ratios and then interpret the results. 3. Financial statement analysis cannot give definite answers. It can point out where further investigation is warranted; but it is a mistake to place too much importance on a simple analysis of financial statement numbers. 4. Accounting and the preparation of financial statements require judgment in making assumptions and estimates. Also, the more frequent the publication of financial statements, the more frequent will be the need to make these estimates, and the greater will be the uncertainty inherent in the financial statements and thus the ratios calculated from them, because many transactions require several quarters or several years for completion. The longer the time it takes to complete a transaction, the more tentative will be the estimates relating to it that affect the financial statements. The short-term incentives, agendas, and personal interests of those who prepare them may affect these estimates relating to long-term events. 5. Ratios usefulness depends on the quality of the numbers used in their calculation. If a companys financial statements are not credible because of poor internal controls or fraudulent financial reporting, then the resulting ratios will be just as unreliable and misleading as the financial statements. However, a critical analysis of ratios can alert an analyst to the possibility of problems in the financial reporting, because he or she may see that the ratios do not make sense. 6. The numbers constitute only one part of the information that should be considered when evaluating a company. Qualitative aspects such as employee morale, new products under development, the companys reputation, customer loyalty, or the companys approach to its social responsibilities are also important. 7. When we compare a company with other companies, their financial statements will probably classify items differently. To the extent possible, we should make adjustments in order to make the statements as comparable as possible. However, this may not always be possible, which makes it difficult to draw conclusions from the comparisons. 8. Many companies are conglomerates, and are made up of many different divisions operating in different, unrelated industries. This can make it difficult to compare any two companies, be-cause while they may share some markets, they seldom share all of the same markets. 9. Companies can choose different methods of computing things such as depreciation expense, cost of goods sold, and bad debt expense. Leases can be reported as operating leases, appearing only in the income statement, or they can be capitalized and reported on the balance sheet. This also affects the comparability of companies. 10. A company may have poor operating results that are caused by several different, small factors. If an analyst focuses on trying to find one major problem, he or she may miss the confluence of many factors.

11. Traditional ratio analysis focuses on the balance sheet and income statement, and therefore cash flow ratios may be overlooked. 12. The goal of financial analysis is to make predictions about how a company will do in the future. However, ratio analysis, which is performed on historical data, may have little to do with what is going on currently at the company. Current data such as news releases from the company must be included in the analysis, as well as historical information. 13. Many financial statement items are based on historical cost values. Ratios based on those historical cost values may be less relevant to a decision than current market values. 14. To be meaningful, a ratio must measure a relationship that is meaningful. For example, the relationship between sales and accounts receivable is meaningful; so the ratios that relate those items are significant. However, there is no meaningful relationship between the average balance of total long-term debt and freight costs, so a ratio relating those items to one another would be useless. 15. Financial statements consist of summaries and simplifications for the purpose of classifying the economic events and presenting the information in a form that can be utilized. In some cases the summarized transactions are recoverable, but in other cases they are not. 16. Financial statements deal only with monetary amounts and do not reflect the decrease in the purchasing power of money that occurs with inflation. Therefore, comparing values over a long period of time may be misleading.

Limitations of Financial Statements in General Limitations of financial statements in general include: Measurements are made in terms of money, so qualitative aspects of a firm are not included. Information supplied by financial reporting involves estimation, classification, summarization, judgment, and allocation. Financial statements primarily reflect transactions that have already occurred; consequently, many aspects of them are based on historical cost. Only transactions involving an entity being reported upon are reflected in that entitys financial reports. However, transactions of other entities, e.g., competitors, may be very important. Financial statements are based on the going-concern assumption. If that assumption is invalid, the appropriate attribute for measuring financial statement items is liquidation value, not historical cost, fair value, net realizable value, etc.

EBIT = Earnings before interest and taxes EBITDA = Earnings before interest, taxes, depreciation and amortization EBT = Earnings before taxes EPS = Earnings per share ROA = Return on assets

ROE = Return on equity 1. Basic Financial Statement Analysis a. Common size statement = line items on income statement and statement of cash flows presented as a percent of sales; line items on balance sheet presented as a percent of total assets. b. Common base year statements = (new line item amount /base year line item amount) x 100 c. Annual growth rate of line items = (new line item amount / old line item amount) 1 2. Liquidity a. Net working capital = current assets current liabilities b(1) Current ratio = current assets / current liabilities b(2) Quick ratio or acid test ratio = (cash + marketable securities + accounts receivable) / current liabilities b(3) Cash ratio = (cash + marketable securities) / current liabilities b(4) Cash flow ratio = operating cash flow / current liabilities b(5) Net working capital ratio = net working capital / total assets 3. Leverage a(1) Degree of financial leverage = % change in net income / % change in EBIT, or = EBIT / EBT a(2) Degree of operating leverage = % change in EBIT / % change in sales, or = contribution margin / EBIT b. Financial leverage ratio = assets / equity c(1) Total debt to total capital ratio = (current liabilities + long term liabilities) / (total debt + total equity) c(2) Debt to equity ratio = total debt / equity c(3) Long-term debt to equity ratio = (total debt current liabilities) / equity c(4) Debt to total assets ratio = total debt / total assets d(1) Fixed charge coverage = earnings before fixed charges and taxes / fixed charges fixed charges include interest, required principal repayment, and leases d(2) Interest coverage (times interest earned) = EBIT / interest expense d(3) Cash flow to fixed charges = (cash from operations + fixed charges + tax payments) / fixed charges 4. Activity a(1) Accounts receivable turnover = credit sales / average gross accounts receivables a(2) Inventory turnover = cost of goods sold / average inventory a(3) Accounts payable turnover = credit purchases / average accounts payable b(1) Days sales in receivables = average accounts receivable / (credit sales / 365), or = 365 / accounts receivable turnover b(2) Days sales in inventory = average inventory / (cost of sales / 365), or = 365 / inventory turnover b(3) Days purchases in payables = average payables / (purchase / 365), or = 365 / payables turnover c(1) Operating cycle = days sales in receivables + days sales in inventory c(2) Cash cycle = Operating cycle days purchases in payables d(1) Total asset turnover = sales / average total assets d(2) Fixed asset turnover = sales / average net plant, property and equipment 5. Profitability

a(1) Gross profit margin percentage = gross profit / sales a(2) Operating profit margin percentage = operating income / sales a(3) Net profit margin percentage = net income / sales a(4) EBITDA margin = EBITDA / sales b(1) ROA = net income / average total assets b(2) ROE = net income / average equity 6. Market / Valuation a(1) Market-to-book ratio = current stock price / book value per share a(2) Price earnings ratio = market price per share / EPS a(3) Price to EBITDA ratio = market price per share / EBITDA per share b. book value per share = (total stockholders equity preferred equity) / number of common shares outstanding c(1) Basic EPS = (net income preferred dividends) / weighted average common shares outstanding (Number of shares outstanding is weighted by the number of months shares are outstanding) c(2) Diluted EPS = (net income preferred dividends) / diluted weighted average common shares outstanding (Diluted EPS adjusts common shares by adding shares that may be issued for convertible securities and options) d(1) Earnings yield = EPS / current market price per common share d(2) Dividend yield = annual dividends per share / market price per share d(3) Dividend payout ratio = common dividend / earnings available to common shareholders d(4) Shareholder return = (ending stock price beginning stock price + annual dividends per share) / beginning stock price 7. Profitability Analysis a(1) ROA = Net profit margin x total asset turnover; (net income / sales) x (sales / average total assets) = net income / average total assets a(2) ROE = ROA x financial leverage; (net income / average total assets) x (average total assets / average equity )= net income / average equity b. Net profit margin x total asset turnover x equity multiplier (DuPont model) = return on common equity; (net income / sales) x (sales / average total assets) x (average total assets) / average equity c. Gross profit margin percentage = (sales cost of sales) / sales d(1) Operating profit margin percentage = operating income / sales d(2) Net profit margin percentage = net income / sales e. Sustainable growth rate = (1- dividend payout ratio) x ROE