Financial Management: Weaknesses of Ratio Essay

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e. they ignore other key indicators and measures of financial performance. Other equally important measures and/or indicators of performance in this case include but they are not limited to employee morale, client service and satisfaction, quality of goods or products, etc.

Another key limitation of ratios is that they are only useful when it comes to the comparison of firms operating in the same industry. Utilizing ratios in the analysis of financial statements of companies in different industries could lead to a distortion of the information desired. This is more so the case given that entities in different industries are more often than not exposed to different regulations, market conditions, etc. In practice, finding two companies that are identical in every way is impossible.

Ratios could also be affected by changes in price levels. According to Lasher (2010), financial statements are often distorted by inflation. In the author's words, "during periods of rapid inflation, inventory, cost of goods sold, and depreciation can badly distort true results" (Lasher, 2010).

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Such changes effectively affect the comparability of financial ratios.

Further, it is also important to note that financial ratios are not immune to manipulation. For instance, as Siegel and Shim (2006) point out, in an attempt to increase its current ratio artificially, a firm could choose to pay off its "current debt with cash just prior to year-end…" an entity's liabilities according to the authors could also be understated by having in place a provision for lawsuits that is largely inadequate. This could effectively distort an entity's debt ratio.

Conclusion

Although their relevance in the determination of an entity's strengths and weaknesses cannot be overstated, financial ratios could in some instances result in conclusions that are largely misleading. In that regard, stakeholders utilizing financial ratios for one reason or another should consider using other measures of financial performance alongside ratios......

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