Understanding the limitations of ratio analysis
It is important to realize that ratios do not actually solve any problems. They merely highlight trends and exceptions that can then be acted upon. Definitions of ratios often vary from one analyst to another. Examples of this are the quick ratio and the acid test. Some analysts refer to the ratio of current assets less inventory divided by current liabilities as the quick ratio while some others refer to that as the acid test.
One school of thought uses the year-end balances for assets in ROA and equity and long-term debt in ROCE. Another school of thought recognizes that companies can manipulate this ratio by posting significant transactions at the year-end, only to reverse them in the new year. They therefore use the average of those balances, which will counter such practices. These differences in approach can lead to vastly different results.
Another criticism of ratio analysis is that it uses historical values and does not...
