There has been widespread debate for several years concerning the declining value of traditional methods of measuring corporate performance and the ability to predict corporate failure. Earnings per share, return on capital employed and other investment ratios are seemingly out of step with the needs of investors. The analysis of financial ratios is to a large extent concerned with the efficiency and effectiveness of management’s use of resources and also with the financial stability of the company. Researchers have developed models which attempt to predict business failure.
Altman’s ‘Z score’ and Argenti’s failure models are examples of such research. However many analysts feel that financial statements require several adjustments before any meaningful evaluation of corporate performance can be made. Analysts often make amendments to corporate profit and net assets before calculating even the most basic of ratios because of their disapproval of certain generally accepted accounting principles and in an attempt to obtain comparability.
Required:
Discuss any FIVE reasons in general terms why the comparison of the a company’s ratios with the ratios of previous years and other companies might be misleading. (5 marks)
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Limitations of inter-period and inter-company comparisons
- The data might need to be adjusted to for inflation if valid comparisons are to be made over time.
- The financial statements might have been prepared using different accounting policies e.g. choice of depreciation and stock valuation policies
- Accounts may be made up to a different date which can significantly affect ratios if the business is seasonal.
- Traditional analysis tends to focus on profitability. Greater attention is needed to be paid to assessing liquidity and the capacity to adapt by reference to cash flow statement.
- The statement of financial position is prepared at a single point in time. This means it is possible to practice window dressing and this can affect ratios.
- The industry average does not indicate the distribution of results around the average. It would be helpful to have quartile and decile figures.