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Finance &
Investment
1
PRESENTED BY
Dr. Ramadan Babers
https://www.linkedin.com/in/ramadan-babers-phd-78976345/
Part_10
2
• Introduction
1 • Quality of financial statements
2 • Creative accounting
3 • Inflation
4 • Over-reliance on ratios
5 • The basis for comparison
Limitations of ratio analysis
3Introduction
• Although ratios offer a quick
and useful method of analyzing
the position and performance
of a business, they are not
without their problems and
limitations
• We shall now review some of
their shortcomings.
41- Quality of financial statements
• It must always be remembered that
ratios are based on financial
statements. They will, therefore,
inherit the limitations of the financial
statements on which they are based
• one important limitation of financial
statements is their failure to include
all resources controlled by the
business
example: goodwill and brands are
excluded because they fail to meet the
strict definition of an asset
52- Creative accounting
• There is also the problem of deliberate attempts to
make the financial statements misleading
• Despite the proliferation of accounting rules and
the independent checks that are imposed, there is
evidence that the directors of some businesses
have employed particular accounting policies or
structured particular transactions in such a way as
to portray a picture of financial health that is in line
with what they would like users to see rather than
what is a true and fair view of financial position and
performance
• This practice is referred to as creative accounting
and it can pose a major problem for those seeking
to gain an impression of the financial health of a
business
62- Creative accounting (cont.)
• The particular methods that unscrupulous
directors use to manipulate the financial
statements are many and varied .
• They can involve overstatement of
revenues, manipulation of expenses,
concealing losses and liabilities and
overstating asset values
• The methods used often involve the early
recognition of sales income gnitroper eht ro
laer on evah taht snoitcasnart selas fo
ecnatsbus
72- Creative accounting (cont.)
When examining the financial statements of a business, a number of checks may be
carried out to help gain a ‘feel ’for their reliability
These can include checks to see whether:
• The reported profits are significantly higher
than the operating cash flows for the period
• The tax charge is low in relation to reported
profits
• The valuation methods used for assets held
are based on historic cost or current values
and if the latter approach has been used
why and how the current values were
determined
• There have been any changes in
accounting policies over the period and
adopted are in line with those adopted
by the rest of the industry
• The auditors ’report gives a ‘clean bill of
health ’to the financial statements
• The ‘small print’ that is, the notes to the
financial statements, is not being used to
hide significant events or changes.
Although such checks are useful, they are not guaranteed to identify creative accounting
practices, some of which may be very deeply seated
83- Inflation
• the financial results of businesses can be
distorted as a result of inflation
• One effect of inflation is that the reported
value of assets held for any length of time may
bear little relation to current values. i.e. the
reported values of assets will be understated in
current terms during a period of inflation as
they are usually reported at the original cost
• This means that comparisons, either between
businesses or between periods, will be
hindered
• A difference in, say, ROCE may simply be
owing to the fact that assets shown in one of
the statements of financial position being
compared were acquired more recently
(ignoring the effect of depreciation on the
asset values)
• Another effect of inflation is to distort the
measurement of profit. In the calculation of
profit, sales revenue is often matched with
costs incurred at an earlier time (time lag)
• During a period of inflation, this will mean that
the expense does not reflect prices that are
current at the time of the sale
• The cost of sales figure is usually based on the
historic cost of the inventories concerned. As a
result, expenses will be understated in the
income statement and this, in turn, means that
profit will be overstated
94- Over-reliance on ratios
• It is important not to rely exclusively on ratios,
thereby losing sight of information contained
in the underlying financial statements
• As we saw earlier in the chapter, some items
reported in these statements can be vital in
assessing position and performance
• For example, the total sales revenue, capital
employed and profit figures may be useful in
assessing changes in absolute size that occur
over time, or in assessing differences in scale
between businesses. Ratios do not provide
such information
• When comparing one figure with another,
ratios measure relative performance and
position and therefore provide only part of
the picture
• When comparing two businesses, therefore,
it will often be useful to assess the absolute
size of profits, as well as the relative
profitability of each business
• For example, Business A may generate £1
million operating profit and have a ROCE of
15 per cent and Business B may generate
£100,000 operating profit and have a ROCE
of 20 per cent
• Although Business B has a higher level of
profitability, as measured by ROCE, it
generates lower total operating profits
105- The basis for comparison
• We saw earlier that if ratios are to be useful,
they require a basis for comparison
• Moreover, it is important that we compare
like with like. Where the comparison is with
another business, there can be difficulties. No
two businesses are identical: the greater the
differences between the businesses being
compared, the greater the limitations of ratio
analysis
• Furthermore, any differences in accounting
policies, financing methods (gearing levels)
and financial year ends will add to the
problems of making comparisons between
businesses
End
Q & A
11

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Part10 finance investment limitations of ratio analysis

  • 1. Finance & Investment 1 PRESENTED BY Dr. Ramadan Babers https://www.linkedin.com/in/ramadan-babers-phd-78976345/ Part_10
  • 2. 2 • Introduction 1 • Quality of financial statements 2 • Creative accounting 3 • Inflation 4 • Over-reliance on ratios 5 • The basis for comparison Limitations of ratio analysis
  • 3. 3Introduction • Although ratios offer a quick and useful method of analyzing the position and performance of a business, they are not without their problems and limitations • We shall now review some of their shortcomings.
  • 4. 41- Quality of financial statements • It must always be remembered that ratios are based on financial statements. They will, therefore, inherit the limitations of the financial statements on which they are based • one important limitation of financial statements is their failure to include all resources controlled by the business example: goodwill and brands are excluded because they fail to meet the strict definition of an asset
  • 5. 52- Creative accounting • There is also the problem of deliberate attempts to make the financial statements misleading • Despite the proliferation of accounting rules and the independent checks that are imposed, there is evidence that the directors of some businesses have employed particular accounting policies or structured particular transactions in such a way as to portray a picture of financial health that is in line with what they would like users to see rather than what is a true and fair view of financial position and performance • This practice is referred to as creative accounting and it can pose a major problem for those seeking to gain an impression of the financial health of a business
  • 6. 62- Creative accounting (cont.) • The particular methods that unscrupulous directors use to manipulate the financial statements are many and varied . • They can involve overstatement of revenues, manipulation of expenses, concealing losses and liabilities and overstating asset values • The methods used often involve the early recognition of sales income gnitroper eht ro laer on evah taht snoitcasnart selas fo ecnatsbus
  • 7. 72- Creative accounting (cont.) When examining the financial statements of a business, a number of checks may be carried out to help gain a ‘feel ’for their reliability These can include checks to see whether: • The reported profits are significantly higher than the operating cash flows for the period • The tax charge is low in relation to reported profits • The valuation methods used for assets held are based on historic cost or current values and if the latter approach has been used why and how the current values were determined • There have been any changes in accounting policies over the period and adopted are in line with those adopted by the rest of the industry • The auditors ’report gives a ‘clean bill of health ’to the financial statements • The ‘small print’ that is, the notes to the financial statements, is not being used to hide significant events or changes. Although such checks are useful, they are not guaranteed to identify creative accounting practices, some of which may be very deeply seated
  • 8. 83- Inflation • the financial results of businesses can be distorted as a result of inflation • One effect of inflation is that the reported value of assets held for any length of time may bear little relation to current values. i.e. the reported values of assets will be understated in current terms during a period of inflation as they are usually reported at the original cost • This means that comparisons, either between businesses or between periods, will be hindered • A difference in, say, ROCE may simply be owing to the fact that assets shown in one of the statements of financial position being compared were acquired more recently (ignoring the effect of depreciation on the asset values) • Another effect of inflation is to distort the measurement of profit. In the calculation of profit, sales revenue is often matched with costs incurred at an earlier time (time lag) • During a period of inflation, this will mean that the expense does not reflect prices that are current at the time of the sale • The cost of sales figure is usually based on the historic cost of the inventories concerned. As a result, expenses will be understated in the income statement and this, in turn, means that profit will be overstated
  • 9. 94- Over-reliance on ratios • It is important not to rely exclusively on ratios, thereby losing sight of information contained in the underlying financial statements • As we saw earlier in the chapter, some items reported in these statements can be vital in assessing position and performance • For example, the total sales revenue, capital employed and profit figures may be useful in assessing changes in absolute size that occur over time, or in assessing differences in scale between businesses. Ratios do not provide such information • When comparing one figure with another, ratios measure relative performance and position and therefore provide only part of the picture • When comparing two businesses, therefore, it will often be useful to assess the absolute size of profits, as well as the relative profitability of each business • For example, Business A may generate £1 million operating profit and have a ROCE of 15 per cent and Business B may generate £100,000 operating profit and have a ROCE of 20 per cent • Although Business B has a higher level of profitability, as measured by ROCE, it generates lower total operating profits
  • 10. 105- The basis for comparison • We saw earlier that if ratios are to be useful, they require a basis for comparison • Moreover, it is important that we compare like with like. Where the comparison is with another business, there can be difficulties. No two businesses are identical: the greater the differences between the businesses being compared, the greater the limitations of ratio analysis • Furthermore, any differences in accounting policies, financing methods (gearing levels) and financial year ends will add to the problems of making comparisons between businesses