There are some inherent problems and limitations to ratio an

There are some inherent problems and limitations to ratio analysis that necessitate care and judgment. Ratios are often not useful for analyzing the operations of large firms that operate in many different industries because comparative ratios are not meaningful. . The use of industry averages may not provide a very challenging target for high-level performance. Inflation affects depreciation charges, inventory costs, and therefore the value of both balance sheet items and net income. For this reason, the analysis of a firm over time, or a comparative analysis of firms of different ages, can be misleading. Ratios may be distorted by seasonal factors, or manipulated by management to give the impression of a sound financial condition (window dressing techniques). Different operating policies and accounting practices, such as the decision to lease rather than to buy equipment, can distort comparisons. Many ratios can be interpreted in different ways, and whether a particular ratio is good or bad should be based upon a complete financial analysis rather than the level of a single ratio at a single point in time. . . Discuss on the above topic and have your input by Saturday 11:59 pm to get full credit Instructions: . Discussion prompt, resource or idea/example iscussion prompt, resource or idea/example . Discussion prompt, resource or idea/example

Solution

It is true that ratio analysis cannot always reveal the true picture of the financial health of the firm and that is because of the various factors at play which ultimately decides the value of the ratio and which may give ambiguous results. For example if we take the example of current ratio, a high current ratio due to high inventory is an example of an inefficient system. However from the credit perspective, a high value of current ratio provides comfort that the company can service its debt requirement through liquid assets.

Similarly a high debt to equity ratio can indicate that the firm would provide high returns to equity share holders, however at the same time it may face problem is servicing the debt repayment requirements. Thus most of the ratios can be interpreted in multiple ways and may have ambiguous conclusions. And hence it may not be wise to decipher the financial health of a company based on the value of a ratio at any point of time.