The first limitation of the ratio analysis is information problems. Ratio analysis is a technique of quantitative analysis and thus ignores qualitative factors such as management skills, track record and the rate of change in the market which may be important in decision making. (Universal teacher publications). The ratios are seen as “red flags” as they do not provide answers to questions raised by the users of an organisations accounting information. They only provide a trend indication and basis for comparison. For example, if the return on capital employed at Kidd’s plc is 20.9%, the potential yield of the business cannot be derived and clearly cannot be achieved. (Benedict & Elliot 2008). The limitations of information problems arises because ratios are not definite measures as they only provide clues to a company’s financial situation thereby, not reflecting the performance of the company. Also out-dated information is likely to be presented in the financial statement which does not give a proper reflection of the organisation current financial position. Furthermore, where historical cost convention is used, valuation of asset could be misleading. Hence ratio based on the information is not good for decision making, and because of the reluctance of companies to divulge information which may be beneficiary to their competitors, they tend to provide dubious and obscure information which has little or no use. (Geoff 2009:225).
The need for comparison: Ratio analysis is a useful tool in analysing the performance of a firm, but would have no usefulness if there is no element of comparison. Ratios need comparators to be meaningful because “a ratio in isolation would be of little use, unless the ratio has a norm with which it can be compared or a standard against which it can be judged”. (Benedict and Elliot 2008:541). Comparisons can be made on the basis of past relationship and statistics within the firm by comparing its achievement to that of its competitors in accordance to the norms and customs of the industry. Though problems are bound to arise because of the unique nature of the business, coupled with the difficulty in finding a similar firm for the comparison purpose. “A typical inter-firm comparison report calculates the company’s own ratio and a quartile analysis of all members so a company can see how it compares with the average in the industry. (Benedict and Elliot 2008:541). Ratios can be manipulated: The third limitation of ratio analysis has to do with the deliberate manipulation of ratios by organisations, so as to present its accounts in a more attractive proposition. The accounting ratio which allows for flexibility in its rules and regulations encourages companies when faced with this problem to come to differing solutions. (Black 2009:225). “This flexibility is seen by some as strength of accounting procedures where the requirements of specific companies allow individual accounting treatments to be adopted where appropriate”. (Black 2009:225). A typical example is when borrowings of a firm are excluded from its capital so as to eliminate any form of bias its inclusion in the financial statement may produce. To cover up its poor financial position, some organisations may resort to “window dressing” which takes the form of “sending customers faulty goods at the year-end and treating them as sales knowing that they will be returned in the following financial period”.(Benedict and Elliot 2008:543).
Current ratio can be defined as the relationship existing between the current assets and liabilities of a business organisation. It is a “measure of general liquidity and it is used to make an analysis for the short term financial position or liquidity of a firm”. (Accounting for management 2011). It gives an overall indication of the performance of a business organisation and how it is able to meet its debt obligations. The current ratio is also known as working capital ratio. (Benedict and Elliot 2008:532). It can be calculated using the formula below: Current ratio = Current assets Current liabilities (Benedict and Elliot 2008: 532) The current ratio consists of two fundamental elements which are:
The current ratio gives an overall insight of an organisations financial stability. It is a “quick measure of an organisations liquidity position and it represents the margin of safety or cushion available to the creditors”. (Accounting for management 2011). “It also acts also as an index of technical solvency and an index of the strength of working capital of a firm”. (Accounting for management 2011). A high current ratio gives an understanding of how a business organisation is able to pay off its debts (current liabilities) in time and when due. This indicates that the business organisation financial position is liquid and solid. (Accounting for management 2011). Also, when the current ratio of the business organisation is low, it gives us an indication that the firm would not be able to pay its liabilities in time without experiencing difficulties. This demonstrates a weak liquidity position. (Accounting for management 2011).
The Limitations of the current ratio are: The problem of assets valuation and “window dressing” tends to exist It is a crude ratio because it ignores the quality of the current assets. (Accounting for management 2011).
Benedict and Elliot (2001) defined return on capital employed as “the ratio that shows the relationship between the profit for the year (before deduction of interest on loan capital and taxation) and the capital employed in the business”. The return on capital employed can also be referred to as the primary ratio. It is a focal point in the determining of business profitability. (Benedict and Elliot 2001). The ratio usually expressed in percentage can be calculated using:
Share capital + Reserves + Non-current liabilities (Atrill & Mclaney 2011) The return of capital employed ratio is one of the major ratios frequently used by business organisations when establishing or setting profit targets. “A viable business should generate a considerably higher return that that available by investing in a bank or other similar interest-bearing deposits”. (Black: 212). The return on capital employed is also vital in the assessment of the performance of funds deployed in an organisation. (Atrill & Mclaney 2011:195). An example of the return on capital employed (ROCE) can be seen below
The Return on capital employed (ROCE) is an important measure of performance of input and output of a firm in the form of profit. (Harvey et al 2001:376). It can be improved by through the following:
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