Theory question 102
Interpretation of AccountsMr. Wazo approached a firm of financial analyst for advice on the viability of Mapo Plc. The analyst employed accounting ratio as a tool for the advice.
(a) Explain the tool employed by the analyst for the advice.
(b) List three types of the tool employed by the analyst.
(c) State five limitations of the tool employed for the advice.
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(a) Accounting ratios: figures that express the relationship between two related items in the financial statements (e.g. profit to sales), used to judge performance, liquidity and position and to compare firms or years.
(b) Any three: profitability ratios; liquidity (solvency) ratios; efficiency (activity/turnover) ratios; investment (shareholders') ratios; gearing (leverage) ratios.
(c) Any five: based on past (historical) figures, so may not predict the future; inflation/price changes distort comparisons; different accounting policies make comparison between firms hard; differences in size and industry; no single ideal ratio; ignores non-money factors (e.g. staff quality); seasonal variations; figures can be window-dressed; interpretation is subjective; different definitions of the same ratio.
Define ratios, give three groups, then five clear limitations.