Which of the following is NOT a reason why financial analysts use ratio analysis?
A) Ratios help to pinpoint a firm's strengths.
B) Ratios restate accounting data in relative terms.
C) Ratios are ideal for smoothing out the differences that may exist when comparing firms that use different accounting practices.
D) Some of a firm's weaknesses can be identified through the usage of ratios.
Which of the following is NOT a limitation related to the usage of ratios when reviewing a firm's performance?
A) Many firms experience seasonality in their operations.
B) Ratios cannot be used to compare firms that are in the same industry if one firm's sales are higher than another firm's.
C) Some firms operate in a variety of business lines, which makes it difficult to make comparisons.
D) Accounting practices differ widely among firms.
Which of the following statements is FALSE?
A) The calculation of the accounts receivable average collection period (ACP) would generally produce a more realistic assessment of how a firm is managing its accounts receivable if the analyst were to calculate the ACP for each month and average the results, than if the analyst were to solely use the fiscal year-end accounts receivable value.
B) If an analyst were to compare the inventory turnover of one firm to that of another, the comparison can be distorted if the two firms use different methods of valuing ending inventory.
C) Assume that two firms are in the same industry and one reports a higher debt ratio than the other. We can safely say that the firm that has the highest debt ratio is the riskier of the two firms.
D) A firm that has a current ratio that is significantly above the industry norm will, as a direct consequence, also have a significantly better return on assets than if its current ratio was below the industry norm.
E) All of the above statements are true.
Which of the following is a limitation related to the usage of ratios when reviewing a firm's performance?
A) Ratios reveal differences in policy and performance between years.
B) Ratios can be used to compare firms that are in the same industry if one firm's sales are higher than another firm's.
C) Financial ratios are designed for the use of creditors, not for managers.
D) Different accounting practices between firms can distort comparisons.
A serious pitfall in the interpretation of financial ratios arises when a company, whose business is seasonal, ends its accounting year on March 31, while most companies in the same industry end their accounting period on December 31.
Differences in accounting practices limit the use of ratio analysis.
Answer: TRUE
Discuss the limitations of ratio analysis.
Answer: It is often difficult to find adequate benchmarks to use, as companies in the same industry can be structured quite differently. Conglomerates are difficult to classify, as they are involved in many different businesses. Firms in different countries use different accounting methods, so ratio analysis can be difficult when trying to compare multinational firms. Many firms have seasonal business, which can skew results, and one-time restructurings are difficult to account for.
