Limitations of financial ratios as a tool to evaluate financial performance Essay
Limitations of financial ratios as a tool to evaluate financial performance
Although financial ratios play a critical role in allowing investors and analysts to give appropriate predictions and a measure of how the company will perform in the future years in terms of stock prices and profitability but a measure problem with these ratios is that they are based on historical data and therefore an attempt to look into the future with the use of these ratios is risky and exposes investors to different kinds of risks such as inflation, cross-border risk and other business related risks. Another limitation of these ratios is related to there limited use on there own.
Certain ratios are insignificant unless they compared with the older data or industry averages. This is a main reason why most analysts want to compare a company’s financial ratio with the industry figures. This also means that an understanding of the business and industry must be there with the investor before a decision is made with regards to purchasing the stock of a company. We also see that firms and their finance departments do try their best to inflate results and window dress the balance sheet and profit and loss figures.
This can lead to over estimated revenues and understated costs which might be discovered later. Therefore it is important to look at different ratios and notes to the statements before conclusions are drawn. There is also a case for companies that have defaulted or there have been instances where scams have been caught and reported by the securities companies and other government departments. Some of the financial ratios also might be impacted by the sudden change in a particular factor or some economic factor that might have a short-term affect on the performance of the company’s bottom line and earnings per share.
To counter this short-term possibility analyst must look at both technical and fundamental analysis before deciding the long-term view on the company. Another issue with financial ratios is that it does not take into account off-balance sheet items that might play a significant role in the profitability and revenue generation of a company this is a case especially for investment banks. We also see that financial ratios only use accounting data and not economic data.
This is also a downside to financial ratios as only limited data is being used to come to important conclusions. (Financial modeling guide, n. d. ) Conclusion MITIE is a strong group with businesses in strategically strong markets where long-term view is extremely positive. The company has strong financials with a prudent policy of avoiding debt in uncertain times. The company has done well considering the difficult time that has been presented by the economic recession and worldwide financial crunch. The company’s profitability looks stronger as we move into 2010 and beyond.
The company also has huge potential in business areas such as infrastructure management and property works especially within the public sector. We say so because a lot of options will be available and a number of opportunities present themselves specifically in the government sector. (Reilly & Brown, 2003) The financial analysis reveals important stuff about the company; firstly the company has very few assets backed by long-term borrowing which shows that the company has an opportunity to raise finances by leveraging its balance sheet.
This could be very effective if some strategic capital is bought or expansion is sought by the company. We also see great potential as the liquidity and cash position of the company s very impressive this is the case because it is very difficult to manipulate important data in the cash flow statement and the cash flow figures therefore a good performance in that sector shows great potential and the healthy performance of the company.
Essentially what is of utmost importance for the company is the fact that it has successfully faced the lowest points of the economic cycle and more importantly it ensured that it developed adequate policies to handle the recessionary times so that in future when liquidity crunch will strike again the company will have adequate measures in place.
Appendix Bibliography: Baker. H, Powell. G, 2005. Understanding financial management: a practical guide. Blackwell Publishing Financial Modeling Guide, n. d. Limitations of Financial Ratios in Financial Modeling.
Viewed February 6, 2010. < http://www. financialmodelingguide. com/financial-ratios/financial-ratio-limitations/> MITIE, 2010. Investors at MITIE, viewed February 7, 2010 < http://www. mitie. com/investors> MITIE, 2010. About us, viewed February 7, 2010 < http://www. mitie. com/about-us> MITIE, 2010. Annual Report 2009, viewed February 7, 2010 < http://www. mitie. com/investors_reports-and-presentations_2009_MITIE-Group-PLC-Annual-Report-2009> Reilly, K Frank & Brown, 2003. Investment Analysis and Portfolio Management, Cengage South-Western Publisher.