1. Ratio analysis

A company reports accounting data in its financial statements. This data is used for financial analyses that provide insights into a companys strengths, weaknesses, performance in specific areas, and trends in performance. These analyses are often used to compare a companys performance to that of its competitors or to its past or expected future performance. Such insight helps managers and analysts improve their decision making.

Consider the following scenario:

Your boss asked you to analyze Green Hamster Manufacturings performance for the past three years and prepare a report that includes a benchmarking of the companys performance. Using the companys last three years of financial reports, youve calculated its financial ratios, including the ratios of Green Hamster Manufacturings competitorsthat is, comparable ratios of other participants in the industryand submitted the report.

Along with calculating the ratios, what else is needed for your report?

Making observations and identifying trends that are suggested by the ratio analysis

Identifying the factors that drive the trends in the ratios

Both of the above

Most decision makers and analysts use five groups of ratios to examine the different aspects of a companys performance. Indicate whether each of the following statements regarding financial ratios is true or false.

Statement	True	False
A company exhibiting a high liquidity ratio is likely to have enough resources to pay off its short-term obligations.
Asset management or activity ratios provide insights into managements efficiency in using a firms working capital and long-term assets.
Debt or financial leverage ratios help analysts determine whether a company has sufficient cash to repay its short-term debt obligations.
One possible explanation for an increase in a firms profitability ratios over a certain time span is that the companys income has increased.
Market value or market based ratios help analysts figure out what investors and the markets think about the firms growth prospects or current and future operational performance.

Ratio analysis is an important component of evaluating company performance. It can provide great insights into how a company matches up against itself over time and against other players within the industry.

However, like many tools and techniques, ratio analysis has a few limitations and weaknesses.

Which of the following statements represent a weakness or limitation of ratio analysis? Check all that apply.

Ratio analysis is conducted using benchmarking techniques.

Inflation can distort balance sheet data.

A firms ratios can lead to conflicting conclusionssome ratios might be good and some bad.