An explanation of the limitations of your analysis, including the ratio analysis technique Essay Example

An explanation of the limitations of your analysis, including the ratio analysis technique

Ratio analysis an investment analysis tool for decision making depict the following limitations

Historical

Every information used in the ratio analysis is derived real past outcome. This doesn’t imply that similar outcome will carry forward to the future. Nevertheless, one might use ratio analysis on pro-forma information as well as comparing the outcome with the past outcome for consistency (Damodaran, 2010).

Historic Vs current cost

The information in the income statement is provided in current cost, while some constituent of the statement of financial position might be provided at historic cost which may vary significantly from the current cost. This difference might lead to uncommon ratio outcomes.

Inflation

If the inflation rate changes in any of the tome under review, this would imply that the numbers aren’t equivalent across the period. For instance, if the inflation rate is 100% in any year, the sales might be twice over the preceding year, when in reality the sales didn’t change.

Aggregation

The information in the annual report that is used for the ratio analysis might have been totaled in a different way in the past, so that the running ratio assessment on the trend line doesn’t contrast the similar information through the whole trend period (Davies, 2013).

Operational changes

A firm might change its fundamental operational layout to an extent that the ratio worked out many years in the past as well as contrasted to the similar ratio at present might be misleading and wrong conclusion about the company’s financial performance. For instance, an implementation of constraints assessment system may lead to reduction in venture in non current asset, while ratio analysis may provide conclusion that the company lets its non current asset to be obsolete.

Accounting policies

The diverse companies might have diverse policy for documenting the similar accounting dealings. The implication is that the contrast of ratio outcome of diverse firms might be like making a comparison of apple and orange. For instance, a company may use accelerated depreciation approach while another firm use the straight line method of deprecation (James, 2015).

Business conditions

The ratio analysis must be placed in the context of the whole business situation. For instance, 60 day sale outstanding may be deem to be poor in times of fast growing sales, but may be perfect at the time of economic contraction when clients are in stern financial situation and not in a position of paying their bills.

Interpretation

It might be hard to establish the justification for the ratio outcome. For instance, the current ratio of 2;1 may appear to be perfect, until it is realized that the firm just made a sale of huge amount of inventory to boost the cash situation of the company. A more comprehensive assessment may reveal that the current ratio will just be at that level for a short time and will just reduce in the future (James, 2015).

Company strategy

It might be risky to conduct ratio analysis contrast between Taylor Wimpey PLC and Barratt Developments PLC that are undertaking dissimilar plans. For instance, one firm might be following the low cost plan and hence it will enthusiastic of accepting low gross margin in exchange of high market position. On the contrary, another firm in similar industry might be focusing on high clients service plan in which its price is high and gross margin is high, but it not achieve the income level of the first

Company (James, 2015).

Point in time

Some ratio extracts information from the statement of financial position. Be advice that the information on the statement of financial position is just as of the closing n period. If there is a rare reduction in the account balances at the closing period may affect the result of the ratio analysis.

In summary, the ratio analysis depicts an assortment of limitation that may be important. Nevertheless, given that one is informed of the issues and the issues of alternatives and supplemental approach to gather as well as interpretation of the information, ratio analysis is still important (William Petty, 2015).

Limitation

The Taylor Wimpey PLC and Barratt Developments PLC are merely sample of UK housing market. The contrast is between the Taylor Wimpey PLC and Barratt Developments PLC and their performance in terms of improved company based on the ratio analysis. There is limitation of risk for verdict making like the scarce information. In real life, there is more background information that must be taken into consideration, the economic situation as well as the housing and more limitations. The market situation in general for the Taylor Wimpey PLC and Barratt Developments PLC is diverse. The business normally appraises the benchmark for the Taylor Wimpey PLC and Barratt Developments PLC in making comparison of some business. Benchmark firms might provide more precise figures as well as average performance for the entire housing industry in UK. There are no benchmark firms to contrast with the Taylor Wimpey PLC and Barratt Developments PLC. On the contrary, the ratio analysis merely considers the financial figures and the ratios, the real financial health situation of the firm are uncertain.

Furthermore, many of the information were collected from the annual repot of the company which may be misleading due to presence of some errors. From the annual report of the company, the users of the report just see what the business want you to see. It is likely misleading circumstance that exists as a result of scarce information. By looking at the past financial performance of the company, the inflation does not count in the ratio. The real worth is dissimilar from the worth from the statement of financial positions. If the inflation rate changes in any of the tome under review, this would imply that the numbers aren’t equivalent across the period. For instance, if the inflation rate is 100% in any year, the sales might be twice over the preceding year, when in reality the sales didn’t change

The time frame is different, it is evident that the annual report for Wimpey Plc is reported until the year ending 21st December 2015 which half year later than the barratt development PLc. The report from the barratt plc is for the year ending 30th June 2015. Since the business situation, inflation as well as other aspects might be changed over period of time, the ratio similarities between the Taylor Wimpey PLC and Barratt Developments PLC is complex. In conclusion, the ratio analysis depicts an assortment of limitation that may be important. Nevertheless, given that one is informed of the issues and the issues of alternatives and supplemental approach to gather as well as interpretation of the information, ratio analysis is still important

Reference

Damodaran, A. (2010) Applied Corporate Finance — Page 552, New York: Cingage Learning.

Davies, H. (2013) Global Financial Regulation: The Essential Guide.

Henderson, S. (2015) Issues in Financial Accounting — Page 991, London: Cingage learning.

James, W. (2015) Financial & Managerial Accounting — Page 992, London: John Wiley.

William Petty, ‎.T. (2015) Financial Management: Principles and Applications — Page 705, London: Springer.