They can be grouped under the headings: Profitability, Liquidity, Gearing and Shareholders’ investment.
Broad Categories of Ratios
Ratios can be grouped into the following four categories:
• Profitability and return
• Debt and gearing
• Liquidity: Control of cash and other working capital items
• Shareholders’ Investment ratios (or stock market ratios)
Limitations of Ratio Analysis
Although ratio analysis can be a very useful technique, it is important to know its limitations:
(a) Availability of comparable information – difficult in identifying which companies are similar and in obtaining enough detailed information about these companies.
(b) Use of historical/out-of-date information – ratios based on published accounts were information which were filed some months after the end of the accounting period. Comparisons may also be distorted by inflation, leading to assets being stated at values that do not reflect replacement costs, and revenue increasing for reasons other than more sales being made.
(c) Ratios are not definitive – Ideal levels vary industry by industry, and even they are not definitive. Companies may be able to exist without any difficulty with ratios that are rather worse than the industry average.
(d) Need for careful interpretation – Business with high liquidity ratios may appear good, but further investigation might reveal that the higher ratios are a result of higher inventory and receivable levels which are a result of poor working capital management.
(e) Manipulation – any ratio including profit may be distorted by choice of accounting policies. For smaller companies, working capital ratios may be distorted depending on whether a big customer pays, or a large supplier is paid, before or after the year-end.
(f) Ratios lack standard form – for example, when calculating gearing some companies will include bank overdrafts, others exclude them.
(source: BPP Learning Media)
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