wk5 answer

Order Description Rewrite this essay avoid plagiarism Q1: Thank you for raising the question about ratio analysis uses and limitations. Analysts use ratio analysis to comparing a firm’s financial statements to its industry averages no matter its size, and its own trends in a simpler form. The ratios shows significant comparing bases about the firm’s results and cash flow. Therefore, the ratio analysis is commonly used by stock and credit analysis because it helps them to calculate the return on capital faster and easier. (Elliott and Elliott, 2013) However, its limitations bound its usefulness. Analysts need to understand the limitations of the ratio analysis in order to complement their analysis and be more assertive. The main limitations are: • Historical information: The information analyzed by ratio analysis refers to the past of the company and not always means that it will continue that way. These include information about costs that could be expressed as its historical value and not its current value and the inflation effect across periods. (Accountingtools.com, n.d.) • Standards: the account policies, assumptions or operational structure of a firm could change over time or the comparable data of the industry could include financial data prepared under different standards, so the conclusions and comparability within the firm or against the industry will not be accrued. (Elliott and Elliott, 2013) • Environment and firm present: the economy, local laws and regulations could affect a variable of the calculation that produces a distortion of the results. For example, in crisis some increase in receivables will be analyzed differently that in a growing economy. Moreover, the firm strategy could have different expected ratios. For example a high current ratio because a resent stocks issue or a market share grows strategy that implies lower margins for a period. (Accountingtools.com, n.d.) • Timing: Balance sheet shows the closing day information, lots of last minute operations can affect that final number that do not reflect the hold period reality. For example, the early payment of a client with excessive cash or seasonality overstocks. In conclusion the ratio analysis is a great tool for a preliminary analysis, but the analysts should be aware of its limitations and make complementary analysis to have a complete view of the firm financial position. Best regards, Enrique del real. References Elliott, B. & Elliott, J. (2013). Financial accounting and reporting. 16th ed. Essex, England: Prentice Hall/Financial Times. Accounting Tools | What are the limitations of ratio analysis? [Online]. Available from: http://www.accountingtools.com/questions-and-answers/what-are-the-limitations-of-ratio-analysis.html (Accessed June 27, 2016). Q2: Thanks for brining up the concept on the rationality of Financial Ratios, their limitations and uses. Financial Ratios, according to Joseph, (2015) plays an important both in the analysis of the financial statements and also on the part of accounting research. On the accounting analysis part, financial ratios help in benchmarking the firm’s performance in comparison with the firms of the same industry. In addition, it helps in measuring problems on the areas of operations, liquidity and profitability. These factors help in analyzing the company’s overall risks and predict the firm’s performance, related to return on stocks and return on assets. Also Financial ratios have demonstrated its vital use in financial reporting. The financial ratio is a combination of a numerator and denominator and is the expression of the relationship between two or more numerals. These two financial amounts can be taken from the balance sheet, wherein, the current ratio is calculated, or it could be from the income statement, wherein the output is the interest earned or it could be a combination of both income statement and balance sheet and is used for the calculation of the return on total assets. It also finds its use in obtaining credit loans from the banks for arriving at a contract between the firm and the financial institutions. To discuss on the limitations of the financial ratios, as discussed earlier, the combination of a numerator and denominator arrives at the financial ratio output. The major limitation is that, any human error in misstating the numerator or denominator ends in the very different output of the resulting ratio. Ways that this could happen, ranges from the collecting of erroneous financial data for analysis and misstating the same data in the equations. Oversight or failure to analyze the collected data could result in unexpected results. At times firms tend to use to management techniques which could lead to erroneous conclusions too. Also the ratios that are derived are based on financial accounting principles, classifications and methods, which may not be consistent or comparatively correct when, used between firms. Though greater flexibility can be availed by firms using GAAP, it could still fail consistency when compared with other firms using a different methodology. The better way to handle the limitations could be addressed by reviewing the accounting principles of the company with the accounting change. These could avoid situations like Last in First out (LIFO) and First in First Out (FIFO). The other limitation is the effect of outliers, which arises a situation called the heteroscedasticity, wherein, the inclusion of certain samples to the outliers could affect the mean and the variance of the regression. The best way handle this could be, developing a methodology to identify the outliers effectively (Joseph, 2015). References: Joseph, F, (2015) ‘Understanding The Limitations Of Financial Ratios’. Academy of Accounting & Financial Studies Journal, 19(3), pp.75–85, [Online]-Available at: ‘http://eds.b.ebscohost.com.liverpool.idm.oclc.org/eds/detail/detail?sid=b88555ce-a30c-4054-b9c1-d22006e95719%40sessionmgr106&vid=2&hid=114&bdata=JnNpdGU9ZWRzLWxpdmUmc2NvcGU9c2l0ZQ%3d%3d#AN=113046436&db=edb'. (Accessed: 29 June 2016). Q3: A firm’s management have the responsibility of directing the company in order to generate profits to increase the wealth of the firm’s shareholders. In order to achieve such objectives, the firm’s data must be analysed and interpreted so that the firm’s performance can be optimised. Ratio analysis assists managers with the interpretation of financial data, and enables them to understand trends and detect strengths and weaknesses of initiatives and strategies. Ratio analysis allows a companies performance to be compared to other firms and industry sectors, and enables actions to be pinpointed that require corrective measures before terminal damage is done. According to Lindsay (2014) ratios can be grouped in to profitability ratios, liquidity ratios, leverage ratios and efficiency ratios. The qualities associated with ratios are: • They must be calculated regularly from time to time • The must be based on accurate and reliable financial information • They must be viewed both as an indicator of wide issues and trends in the long-run and also at a particular point in time. • They must be used internally for performance evaluation • They must also be used to compare the company’s performance relative to its industry peers. • Must not be relied upon solely for making decisions, as there are other factors at play According to Lindsey (2014), despite the many positive reasons associated with the use of ratios, some limitations with the use of efficiency ratios do exist, such as: • Effect of inflation – inflation may result in distortion of data, and especially with regard to the firm’s balance sheet. As such, profits and the firm’s bottom line are affected. • Seasonal influences - a company may accumulate stocks and buy equipment in preparation for a “high-season” when sales are higher. As such, the efficiency ratios may be lower, though this is not the case. • Different Accounting Practices – different firms can adopt varying practices, as such discretion should be exercised when using the efficiency ratio. • Most large companies, or conglomerates, operate in different business sectors. This results in it being hard to obtain solid data for cross-comparison. References: Lindsay, T., (2014), ‘Types of Efficiency Ratios Used in Measuring Business Performance’, udemy [Online], Available from: https://blog.udemy.com/efficiency-ratios/ Accessed: 29.06.16 Q4 the Cash Conversion Cycle metric to our discussions. According to Elliott & Elliott (2013), the Cash Conversion Cycle, or the Cash Cycle as it is also referred to, measures the number of days required for acquiring inventory, selling it, and converting the sales into cash. It is a metric that is essentially used in order to assess the efficiency of the firm’s ability to employ short-term assets and liabilities to generate cash for the company (Investopedia, n.d.). The Cash Cycle is calculated as follows: Cash Cycle = Account Receivable days + Inventory days - Accounts Payable days The management of the Cash Cycle is critical to the cash flow and profitability of the firm Elliott & Elliott (2013), and is also used to assess the liquidity risk as a result of growth, by assessing the length of time that the firm will be deprived of cash should it seek to increase sales through investment in resources. A low Cash Cycle helps investors identify well managed firms, and can be combined with metrics such as return on equity and return on assets as an indicator of management effectiveness and company viability (Investopedia, n.d.). As with many metrics and financial ratios, the Cash Cycle is of little use on its own, yet when used in conjunction with data from different companies or time periods, it proves to be a highly beneficial comparative technique. Should a firm’s cash cycle increase over consecutive years, it display that the firm is taking longer to turn its inventory into cash, and therefore indicates depletion in management efficiency. References: Elliott, B. and Elliot, J. (2013). Financial Accounting and Reporting, 16th Edition, Pearson Education Limited, UK. Investopedia, (n.d.), ‘Cash Conversion Cycle – CCC’, Investopedia [Online], Available from: http://www.investopedia.com/terms/c/cashconversioncycle.asp Accessed: 28.06.16