Limitation of financial analysis

Introduction

Business financial strength is of vital concern to business owners, corporate managers, and lenders. Efficiency and cost control are keys to success to many companies in the current world. It is also very important to understand a company’s financial performance relative to its industry as all companies compete in the market place on a local, regional, national or international stage. When measuring the accomplishment of an organization and the financial performance of a company, the ratio analysis is the most important measurement which reflects their good working strength but again they don’t come without limitations for instance use of financial statements includes accounting, stock market and management related limitations which involves distorting the raw data used to derive financial ratios

The current ratio is the most important liquidity ratio since it measures the relative relationship between the firm’s current assets and current liability. This ratio can ascertain the firm’s ability to meets its short-term obligation by using the most liquid assets of the company. The higher the ratio, the better since this is translated to mean that the company can meet its short-term debt obligations without any difficulty. For instance, the two companies are not badly off in terms of meeting their short-term debt obligation. Visa Inc. is in a position to pay 1.9 times its current obligation hence this is a signal of a going concern business for investors. However, its counterpart American Express is in a position to pay up to 1.7 times of its current liability thereby making it also to be in good financial health. Investors, in this case, will invest more in Visa Inc. whose payment ability is higher than that of American Express but investors do not need to rely on this ratio alone to draw a conclusion.  Calculation of current ratio includes inventory, which may lead to overestimation of the liquidity position in the case of American Express.

At management and investor level, ratio analysis using financial statements can also leave out a number of important aspects of a firm’s success such as key intangibles, like the brand, relationships, skills, and culture. These are primary drivers of success over the longer term even though they are absent from financial statements. For example in the case of that Visa Inc. can effectively generate profit after tax at an increasing rate since it had an increase in net profit after tax of 3.3% since 2013. But the ratios do not tell how the company fared regarding social responsibility or the skills used to achieve the results.

Using ratio analysis to view a company’s financial performance is undermined in that when used alone it can present an overly simplistic view of the company by distilling a great deal of information into a single number or series of numbers. Also, changes in the underlying information ratios can hamper comparisons across time and inconsistencies within, and the industry can also complicate comparisons

Another limitation is that the management of the company to ensure that their operating expenses are lower than their operating profits to avoid sending a bad signal to the market. A higher operating profit shows the healthy financial condition of the company hence manager are said to have ensured that the company makes profits rather than losses. This is achieved using the operating profit margin ratio and while both companies posted impressive figures, for instance, the operating profit of Visa Inc. has been increasing though not at a constant rate since it was 61.3% in 2013, 60.9% in 2014 and 65.3% in 2015. This increase is clear indication that the firm has a sound financial health since its total operating expense is less than 50% while that of American Express has an operating profit margin ratio that has been decreasing from 30.6%, 35.2% and finally to 32%. Using this ratio can be misleading since, such an organization may compromise on growth and long-term investment as it tries to control recurrent expenditures. Investors may not be able to the details of recurrent expenditure foregone to access the management’s expenditure decisions.

Inflation too plays a major role in assessing a company’s financial performance as inflation may have badly distorted a company’s balance sheet. In this case, profits will also be affected thus a ratio analysis of one company over time, or a comparative analysis of companies of different ages must be interpreted with judgment. For example, the operating profit of Visa Inc. has been increasing though not at a constant rate since it was 61.3% in 2013, 60.9% in 2014 and 65.3% in 2015. This increase is clear indication that the firm has a sound financial health since its total operating expense is less that 50%  while, American Express has an operating profit margin ratio that has been decreasing from 30.6%, 35.2% and finally to 32%. This shows that the firms operating expenses covers almost 70% of its total revenue, but these figures do not give the value of inflation aspect of the economy thus unreliable for determinatio

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