Constraints of rate analysis for cross sectional
Paper type: Financing,
Words: 388 | Published: 01.08.20 | Views: 259 | Download now
Proportion analysis can be described as useful technique for comparing a company’s performance and position with other businesses. However , these kinds of comparisons may be misleading. A number of the limitations of ratio evaluation for cross-sectional comparisons will be discussed under: Accounting policies: Accounting laws allow businesses to choose accounting policies and use acumen while setting up accounts. This kind of a independence leads to variations in the accounts of businesses, which in turn distorts cross-sectional firm comparisons. Historical cost: If companies are of different ages, their financial statements will include noncurrent assets bought at several times during the past which will usually be noted at historical cost.
This will imply the different businesses have different publication values of asset, therefore affecting all their financial assertions even if the companies are otherwise similar (Ireland and Leiwy, 2011). Creative accounting: Companies often present overpriced revenues and reduced liabilities on the economical statements. Especially, they tend to window dress during profits results months.
These tips make traders believe that corporations have a solid financial position.
However , this kind of creative accounting misleads experts using financial accounting and ratios intended for cross-sectional side by side comparisons. Different risk profiles: Businesses have different economic and industry risk single profiles. Companies in the same industry may confront different economic and market risks. For instance , a company using a low debt ratio may well indicate better financial position. Nevertheless , banks might not have presented loans towards the company owing to the company’s low creditworthiness or high economical risk profiling.
Another company in the same industry may well have a decreased financial risk profiling, and it may get loans at a reduced rate for growth. But , the financial statement will only show a high gearing rate. In this case, ratio analysis leads to inappropriate interpretations and conclusions about both the businesses. Qualitative factors: Ratio analysis does not consider qualitative elements such as administration quality, top quality of resources, social responsibilities, goodwill and so forth
Despite the restrictions discussed previously mentioned, financial ratio analysis is still useful in examining a company’s financial performance. Ratios provides a functional knowledge of a company’s operations in the event used smartly. Analysts have to understand the restrictions in the synthetic method and
make the necessary changes.