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:

You work as an analyst at a credit-rating agency, and you are comparing firms in the construction and engineering sector. One company in the portfolio of companies you are analyzing is a Chinese firm. This firm stands out in the ratio analysis, because the companys financial ratios are substantially lower than identical financial ratios of the other firms in the sector. You do not dissect the results of the ratio analysis and categorize report this firm as an under-performing company.

Which of the following statements about your analysis report is true?

The analysis likely includes incorrect and misleading conclusions.

The ratios provide an accurate and thorough representation of the Chinese companys performance.

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 are true or false?

Statement	True	False
Debt or financial leverage ratios help analysts determine whether a company has sufficient cash to repay its short-term debt obligations.
Asset management or activity ratios provide insights into managements efficiency in using a firms working capital and long-term assets.
A company exhibiting a high liquidity ratio means it is likely to have enough resources to pay off its short-term obligations.
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.
One possible explanation for an increase in a firms profitability ratios over a certain time span is that the companys income has increased.

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.

A firm may operate in multiple industries.

A firms financial statements show only one period of financial data.

Different firms may use different accounting practices.