Benefits & Limitations of Ratios Flashcards
What are the broad limitations of Ratio Analysis?
Give 6:
1) Only EPS has an exact definition
2) Calculations vary analyst to analyst
3) Use historic data
4) Can be window dressed
5) Limited use in isolation
6) Differences between GAAP & IFRS
Why can’t companies in different industries be compared?
Differing characteristics
- capital intensity
- margins & volume differ
Why can’t all companies in the same industry be compared?
Different stages of building the company
- early companies have more debt
- older companies have better cash flow
What are the limitations of profitability ratios?
- Business models vary business to business - makes it hard to compare
Must compare similar businesses
What are the limitations of liquidity ratios
- All banks in GFC had similar dangerous ratios (this was misleading)
- Liquidity is dependant on wider market environment
How do accounting policies limit ratios?
They must be applied consistently
e.g. if you revalue an asset then depreciate profit will be lower
What is window dressing?
Companies trying to make their ratios appear in best light
Illegal and deceptive practices
Give examples of window dressing
1) B&B transactions
1.5) Circular Transactions
2) Postponing payments
3) Booking revenue early
4) Repay debt at period end
5) Sell poor invstmnts to buy good ones at period end
6) Give false statements about business or performance
Who window dresses?
1) Corporates
2) States
3) Countries
Name 4 accounting distortions:
1) Comparing full year transaction with year end balance
2) Seasonality of Revenues
3) Group Financial Data
4) Comparing like with like
How does seasonality cause distortions?
Distorts figures like trade receivables collection period
What is comparing like with like
1) Depreciation / accounting methods should be the same
2) Similar / comparable businesses must be used
