Question

Ratio analysis is an important component of evaluating company performance. It can provide great insights into how a company matches up against itself over time and against other players within the industry.

However, like many tools and techniques, ratio analysis has a few limitations and weaknesses.

Which of the following statements represent a weakness or limitation of ratio analysis? Check all that apply.

Market data is not sufficiently considered.

Window dressing might be in effect.

Seasonal factors can distort data.

Answer 1

Window dressing might be in effect.

Seasonal factors can distort data.

Answer 2

Window dressing is something a firm may do at critical times when it wants to temporarily enhance its image. A firm uses window-dressing techniques to enhance certain aspects of its business so that analysts looking at the firm’s financial statements may assess its performance or position as being stronger than it actually is.

Seasonal factors may distort data for firms that do the majority of their business at a certain point during the year. This can certainly cause distortions during ratio analysis. A good way to reduce the amount of distortion is to analyze ratios on a month-to-month basis to get a better picture of the firm as it progresses throughout its normal operating cycle.

It is assumed that market data are sufficiently considered when conducting ratio analysis. This does not represent a weakness or limitation of ratio analysis.

Answer 3

A company exhibiting a high liquidity ratio means it is likely to have enough resources to pay off its short term obligations	TRUE
Asset management ratios provide insights into managements efficiency in using a firms working capital and long term assets	TRUE
Debt management or financial leverage ratios help analysts determine whether a company has sufficient cash to repay its short term debt obligations	FALSE
One possible explanation for an increase in a firms profitability ratios over a certain time span is that the company's income has increases.	TRUE
Market-value or Market-based ratios help analysis figure out what investors and the markets think about the firms growth prospects and current and future operational performance.	TRUE
Below statements represents weakness or limitations of ratio analysis
Seasonal factors can distort data.
Window dressing might be in effect.