Ratio analysis A company reports accounting data in its financial statements. This data is used for financial analyses that provide insights into a company’s strengths, weaknesses, performance in specific areas, and trends in performance. These analyses are often used to compare a company’s performance to that of its competitors or to its past or expected future performance. Such insight helps managers and analysts improve their decision making.
Consider the following scenario:
You work as an analyst at a credit-rating agency, and you are comparing firms in the construction and engineering sector. One company in the portfolio of companies you are analyzing is a Chinese firm. This firm stands out in the ratio analysis, because the company’s financial ratios are substantially lower than identical financial ratios of the other firms in the sector. You do not dissect the results of the ratio analysis and report this firm as an under-performing company. Along with calculating the ratios, what else is needed for your report?
A. Making observations and identifying trends that are suggested by the ratio analysis.
B. Identifying the factors that drive the trends in the ratios.
C. Both of the above.
Most decision makers and analysts use five groups of ratios to examine the different aspects of a company's performance. Indicate whether each of the following statements regarding financial ratios are true or false?
Statement True False
A company exhibiting a high liquidity ratio means it is likely to
have enough resources to pay off its short-term obligations.
Asset management ratios provide insights into management's
efficiency in using a firm's working capital and long-term assets.
Debt management or financial leverage ratios help analysts
determine whether a company has sufficient cash to repay its
short- term debt obligations.
One possible explanation for an increase in a firm's profitability
ratios over a certain time span is that the company's income
has increased.
Market value ratios help analysts figure out what investors and
the markets think about the firm's growth prospects or current
and future operational performance.
Ratio analysis is an important component of evaluating company performance. It can provide great insights into how a company matches up against itself over time and against other players within the industry. However, like many tools and techniques, ratio analysis has a few limitations and weaknesses. Which of the following statements represent a weakness or limitation of ratio analysis?
A. Seasonal factors can distort data.
B. Window dressing might be in effect.
C. Market data are not sufficiently considered.