My Financial Ratios Discussion:
Referencing this week’s readings and lecture, what are the limitations of financial ratios? Classify your answer into at least the following categories: liquidity ratios, activity ratios, leverage ratios, and profitability ratios.
Respond to at least two of your classmates’ posts.
Quentins Discussion Reply and include sources provided:
According to our weekly lecture, Cain defined the following four ratios, namely liquidity ratios, which “help determine whether a company is liquid enough to cover up its current liabilities.” Activity ratios “establish how a company makes use of its resources through comparison of certain activities.” Leverage ratios “establish the level of debt owed to creditors by a company and whether such a company is in a position to pay its long-term liabilities.” Lastly, profitability ratios “establish whether it is operating at a profitable level and measure the success of the company in the industry” (Cain, 2018, Week 6 Lecture).
The limitations of these financial ratios vary depending on the type of ratio presented. For the liquidity ratio, limitations may rise due to the fluctuation of sales at certain times of the year. Activity ratios may experience a type of constraint due to the late customer payments and also seasonal sales being higher than others. Leverage ratios experience issues when debt is too high being that the debt still has to be paid at some point. For profitability ratios also depend on whether or not companies can pay their debts and how much profit is being generated. Other limitations include inaccurate data on statements, times of inflation, and fixed assets at cost (Epstein, 2014).
Cain, M. (2018). Week 6 Lecture. Retrieved from https://ashford.instructure.com/courses/21789/pages/week-6-weekly-lecture?module_item_id=1104041
Epstein, L. (2014). Financial decision making: An introduction to financial reports [Electronic version]. Retrieved from https://content.ashford.edu/
Edwards Discussion reply and use sources in reply:
While financial ratios can be used to access a company’s performance in regards to their financial health, they have multiple limitations that can prevent an analyst from getting a full examination. Liquidity ratios for instance may be used by a financial institution when they are determining whether the borrower has enough cash flow to pay of current debt. However, using a liquidity ratio would get inaccurate results if the company measured their performance multiple times a year because the numbers could fluctuate. Activity ratios can be used by an analyst to see how much of a company’s assets can be converted into cash. However, “assets are valued at cost and may not reflect the current market value of assets which can distort ratios that use asset values, especially when comparing a company with primarily older assets to a company just starting up” (Epstein, 2014, p. 6.2).
Profitability and leverage ratios are used to determine how money a company makes and how much capital they have but they are inefficient if a financial analyst is looking for future projections. Not to mention that all the financial ratios mentioned will have inadequate results if the company only has high level performances during peak seasons. A company that sells lawn equipment will have peak sales during the warms but will have low sales when it gets cold. Conclusively, all financial ratios would be difficult to use if a company sells items in different industries because it would be too hard to analyze what other corporations to deploy for products sold comparison.
Dobosz, J. (2013). Ten ratios to make you money in stocks. Forbes. Retrieved from http://www.forbes.com/sites/johndobosz/2013/09/25/10-ratios-to-make-you-money-in-stocks/ (Links to an external site.)Links to an external site.