Question

A company reports accounting data in its financial statements. This data is used for financial analyses that provide insights into a company’s strengths, weaknesses, performance in specific areas, and trends in performance. These analyses are often used to compare a company’s 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 for a brokerage firm. Your boss asked you to analyze Blue Parrot Manufacturing’s performance for the past three years and to write a report that includes a bench marking of the company’s performance.

Which of the following components would be best for you to include in your financial statement analysis?

Financial statements based solely on information given to analysts and brokerage firms

A comparison of the firm’s performance with other firms in the same industry based on their financial ratios

Most decision makers and analysts use five groups of ratios to examine the different aspects of a company’s 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 management’s efficiency in using a firm’s 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 firm’s profitability ratios over a certain time span is that the company’s income has increased.
Market value or market based ratios help analysts figure out what investors and the markets think about the firm’s 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.

Window dressing might be in effect.

Market data is not sufficiently considered.

Seasonal factors can distort data.

Answer 1

1. Which of the following components would be best for you to include in your financial statement analysis?

A comparison of the firm’s performance with other firms in the same industry based on their financial ratios

2.

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

3. Which of the following statements represent a weakness or limitation of ratio analysis?

Window dressing might be in effect.

Seasonal factors can distort data.