Journal on Financial Ratio Analysis

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Session 15: Limitation of Ratio Analysis
Learning Objective

Explain to the participants on the limitation of ratio analysis. Important Termss

Creative accounting.
Accounting Policies.
Limitations of Ratios

Accounting Information
Different Accounting Policies
The choices of accounting policies may distort inter company comparisons. Example IAS 16 allows valuation of assets to be based on either revalued amount or at depreciated historical cost. The business may opt not to revalue its asset because by doing so the depreciation charge is going to be high and will result in lower profit. Creative accounting

The businesses apply creative accounting in trying to show the better financial performance or position which can be misleading to the users of financial accounting. Like the IAS 16 mentioned above, requires that if an asset is revalued and there is a revaluation deficit, it has to be charged as an expense in income statement, but if it results in revaluation surplus the surplus should be credited to revaluation reserve. So in order to improve on its profitability level the company may select in its revaluation programme to revalue only those assets which will result in revaluation surplus leaving those with revaluation deficits still at depreciated historical cost. Information problems

Ratios are not definitive measures
Ratios need to be interpreted carefully. They can provide clues to the company's performance or financial situation. But on their own, they cannot show whether performance is good or bad. Ratios require some quantitative information for an informed analysis to be made. Outdated information in financial statement

The figures in a set of accounts are likely to be at least several months out of date, and so might not give a proper indication of the company's current financial position. Historical costs not suitable for decision making

IASB Conceptual framework recommends businesses to use historical cost of accounting....
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