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

ratio analysis is used to compare information taken from the financial statements to gain general understanding of the results, financial position, and cash flows of a business.

following are the potential pitfalls of ratio analysis:

Accounting policies: different companies may have different policies for recording the same accounting transaction.for e.g one company uses accelerated depreciation while another company uses straight line depreciation, or one company records a sale at gross while the other company does at net value

Interpretation: it can be quite difficult to ascertain the reason for the results of a ratio. for eg a current ratio of 2:1 might appear to be excellent , until you realize that company just sold a large amount of its stock to bolster its cash position

Operational changes: a company may change its underlying operational structure to such extent that a ratio calculated several years ago and compared to the same ratio today would give misleading conclusion.