Question

As your text describes, ratio analysis is a common technique in financial analysis. One of your colleagues states that a thorough ratio analysis is all that is needed in considering the financial health of a company. Although you agree that ratio analysis is a helpful guide, there may be some potential pitfalls in ratio analysis.

Discuss at least three potential issues in utilizing ratio analysis that you would share with your colleague. In addition, calculate a liquidity, profitability, and efficiency ratio from your Week Six company to demonstrate your observations.

Develop a 200 – 300 word explanation supporting your findings. The company I chose is Amazon

Answer 1

Potential issues in utilizing ratio analysis are:

(1): Use of past results and performance – Ratio analysis makes use of past and historical financial data when determining the financial health of a company. Past performance of a company may not necessarily be an indicator of its future performance and hence ratio analysis cannot be used to determine the future financial performance of a company.

(2): Changes in accounting policies – If a company has changed its accounting policies then this will have a significant impact on its financial reporting. Change in accounting policies will lead to alteration in financial ratios and in many cases the ratios becomes incomparable.

(3): Manipulation of financial statements – Ratio analysis is based on financial data and in some cases companies fudge their data through means like window dressing. This may lead to a situation in which ratios shows a misleading and false picture.

The ratios for Amazon are shown below. The ratios are based on financial data from its 2017 annual report:

1	Liquidity ratio	Values	Ratio
	Current ratio = current assets/current liabilities	60197/57883	1.04
2	Profitability ratio
	Net profit margin ratio = net profit/net sales	3033/118573	0.03
3	Efficiency ratio
	Inventory turnover = cost of sales/average inventory	111934/(11461+16047)/2	8.14

From the above ratios we can see that Amazon’s current ratio is 1.04, its net profit margin ratio is 0.03 (or around 3%), and its inventory turnover is 8.14 times. The above ratios are just an indicator of the financial performance of Amazon for the year 2017 and cannot be used to systematically gauge or determine the company’s performance for 2018. The future may be completely different from the apst for Amazon and financial ratios are not an indicator of future performance.

(228 words - excluding the table)