Research Paper Help on Limitations of Ratio Analysis

Limitations of ratio analysis

Ratio analysis carries the potential of providing valuable information relating to a company’s operations and financial position. Despite this potential, ratio analysis bears limitations. Potential hitches are listed below; 

  • Ratio analysis is prone to distortion by seasonal factors (Lesáková, 2007). For instance, the inventory turnover ratio of a food processing company is bound to vary whenever the balance sheet figures involved in the inventory are those obtained immediately before or after the end of the season.
  • Generalization of whether a given ratio is good or bad can prove difficult (Lesáková, 2007). For instance, a high fixed assets turnover ratio designates either an organization’s efficiently utilized resources or the lack of capital, implying the inability to afford enough assets.
  • An organization can have aspects of both good-looking and bad-looking ratios, hence making it a challenge to pinpoint whether the firm is in a strong or weak position (Lesáková, 2007).

The use of debts, also known as financial leveraging, can either positively or negatively impact a firm’s ROE. At a perfect financial leverage, adding debt corresponds to an increase in an organization’s ROE due to an increase in stock volatility. However, financial leveraging when a company’s ROE is low may lead to a decrease in its equity, since the risk of investment outweighs the expected returns (Aydemir, 2007).

Adding debt to the capital structure carries both advantages and disadvantages. On one hand, the use of debt as a capital structure is advantageous since interest is tax deductible and thus reduces the cost of debt; profits are not shared as debt-holders are limited to only fixed returns, while being denied voting rights (Baker, 2005). On the other hand, debt as a capital structure is disadvantageous as it increases risk levels and raises interest rates required to cover the risks (Baker, 2005).

References

Aydemir, A. C., Gallmeyer, M., & Hollifield, B. (2007). Financial leverage and the leverage effect-a market and firm analysis. Tepper School of Business, 142.

Baker, H. K., & Powell, G. E. (2005). Understanding Financial Management: A Practical Guide. Oxford: Blackwell Pub.

Lesáková, Ľubica. (2007). Uses and Limitations of Profitability Ratio Analysis in Managerial Practice. In International Conference on Management, Enterprise and Benchmarking (pp. 1-2).