Ratio analysis and interpretation - Limitations of ratios an...

Learning Outcomes

After reviewing this article, you will be able to explain the key limitations of ratio analysis in assessing financial performance, identify the effects of accounting policy choices and window dressing tactics on ratio interpretation, and describe why ratios may not reflect the true financial position or fundamental trends of an entity. You will also gain awareness of how management can manipulate reported results, and how to approach ratio analysis critically for the ACCA Financial Reporting exam.

ACCA Financial Reporting (FR) Syllabus

For ACCA Financial Reporting (FR), you are required to understand not only how to calculate and interpret ratios, but also the inherent limitations and risks involved. In your revision for this topic, focus on:

• The problems of using historic cost financial statements to assess future trends and performance
• How financial statements may be manipulated through accounting policy choices and window dressing
• The impact of seasonality and non-representative year-end balances on ratio analysis
• The effect of changes and differences in accounting policies between entities or periods
• Practical difficulties in comparing ratios across companies and time periods

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is NOT a limitation of ratio analysis?
   1. It can highlight broad trends
   2. It may be distorted by differences in accounting policies
   3. It relies solely on historical figures
   4. It always predicts future cash flow accurately

2. What is "window dressing" in the context of published financial statements?

3. Why might the statement of financial position figures at year-end not represent typical values for the period?

4. True or false? Changes in accounting policy will need to be taken into account when comparing ratios year on year.

5. List two ways managers can manipulate reported ratios without improving core business performance.

Introduction

Ratio analysis is widely used to assess business performance and financial position, but its results can be misleading or even manipulated. Exam questions will expect you to move beyond calculation and consider the reliability, comparability, and ethical challenges involved in interpreting ratios.

This article clarifies:

• Why ratios may not tell the whole story
• How window dressing and choice of accounting policy affect results
• What to watch for when using ratios in assessment scenarios

Limitations of Ratio Analysis

Financial ratios can provide useful indicators when interpreted correctly. However, their usefulness is restricted by several practical and ethical issues.

Reliance on Historic Information

Most ratios use figures from published financial statements, which are based on transactions and conditions existing in the past. This presents two main limitations:

• Financial statements are prepared under the historic cost convention and may not reflect current market values.
• Past performance does not always predict future results, especially in times of inflation, economic change, or rapidly evolving industries.

Key Term: historic cost accounting
The practice of recording assets and liabilities at their original transaction value, not current replacement value.

Impact of Accounting Policies

Comparisons using ratios assume financial statements were prepared on a comparable basis. However, companies have discretion over many policy choices, including depreciation methods, inventory valuation (FIFO vs. AVCO), impairment reviews, and even the timing of revenue recognition.

• Differences in accounting policies between entities (or from period to period) can render ratios incomparable or misleading.
• Changes in accounting policy may obscure fundamental trends, especially if not restated for previous periods.

Key Term: accounting policy
The specific principles, bases, and rules adopted by an entity in preparing its financial statements.

Non-Representative Year-End Balances

Statements of financial position show a snapshot on the reporting date, but many items, such as inventory, receivables, and payables, fluctuate during the year. Companies may time actions to distort year-end balances—a practice known as window dressing.

• Seasonal trading can result in exceptionally low inventory or payables at year-end.
• Borrowing may be temporarily repaid before the statement date to give a lower gearing ratio.

Window Dressing and Creative Accounting

Management can take deliberate steps to improve the appearance of their results without genuinely strengthening performance or position. Common window dressing tactics include:

• Accelerating the collection of receivables at year-end to boost cash figures and liquidity ratios
• Delaying creditor payments to improve cash or current ratio
• Adjusting depreciation estimates or useful lives to raise reported profits
• Selling assets with gains, or not writing down obsolete inventory, to inflate profitability for a period

Key Term: window dressing
Actions taken by management close to the reporting date to make the financial statements appear stronger than is actually the case.

Key Term: creative accounting
The use of accounting techniques or policy choices to present overly favourable financial results, staying technically within the rules but potentially misleading users.

Worked Example 1.1

A retailer whose business is highly seasonal arranges for suppliers to collect payments just after year-end, and offers heavy discounts to customers to increase year-end cash and reduce inventories. How might this affect liquidity and turnover ratios for the reporting date? Would these ratios represent the business's typical financial position?

Answer:
By delaying payments to suppliers, the business reports a lower payables balance and higher cash at year-end. Selling inventory at discounts artificially lowers closing stock, enhancing inventory turnover. However, these ratios do not reflect average conditions—they have been managed for presentation purposes and could mislead users about cash flow, inventory management, or liquidity risk.

Limitations in Comparability Across Entities and Periods

Ratios are only comparable if the bases for preparation are similar. Problems include:

• Entities may adopt different valuation methods, provisions, or leasing treatments.
• Sector averages may include companies with different year-ends or varying business models.
• Changes in accounting standards, such as new rules on revenue or leasing, complicate comparisons over time.

Illustration: Ratio Distortion by Accounting Policy

Suppose Company A uses straight-line depreciation, while Company B adopts an aggressive reducing balance method for the same class of assets.

Their profit and asset turnover ratios will differ, even if both entities have identical equipment and operations, simply due to faster expense recognition in Company B. This limits the usefulness of any direct ratio comparison.

Exam Warning

Examiners often include scenarios where ratios appear to improve, but root causes are due to changes in accounting estimates, policy, or cut-off manipulation. Always check for changes in methods, year-end timing, or exceptional items before drawing firm conclusions.

Window Dressing in Practice

Window dressing can be a one-off manipulation or part of an ongoing approach. Common motives include:

• Satisfying loan covenant requirements (e.g., minimum current ratio)
• Maintaining a track record of steady profit growth
• Influencing share price or tax liabilities
• Supporting bonus or incentive targets

ACCA expects ethical awareness: manipulating accounts to mislead users breaches professional standards and can lead to disciplinary action.

Worked Example 1.2

A company with a gearing ratio close to an agreed bank covenant repays a large bank loan on 29 December, with funds borrowed back from the same bank in January. What impact does this have on the gearing ratio at the reporting date? Should this ratio be relied upon by a prospective lender?

Answer:
The year-end gearing ratio is significantly reduced by the repayment, but this does not reflect the company's usual debt profile. Reliance on a single date ratio can be misleading; average balances or review of subsequent events may reveal the true risk position.

Revision Tip

When asked to interpret ratios in the exam, always check the notes for:

• Changes in accounting policy or estimates
• One-off transactions or exceptional items
• Seasonality or cut-off manipulation This will help you comment critically, not just mechanically calculate.

Summary

Ratio analysis is a useful starting point for understanding financial statements, but users must be alert to its limitations. Historic cost, management judgment, policy differences, and window dressing can all distort results. Always use ratios as part of a wider interpretation, considering both quantitative and qualitative information, and be sceptical where sudden improvements lack a clear operational reason.

Key Point Checklist

This article has covered the following key knowledge points:

• Ratios are limited by reliance on historic cost and past data
• Different accounting policies can make ratio comparisons meaningless
• Seasonality and non-representative year-end figures distort ratios
• Window dressing and creative accounting can manipulate reported ratios
• Always check for policy changes, exceptional items, or timing effects when interpreting ratios
• Ratio analysis should be used alongside other information—not as sole evidence

Key Terms and Concepts

• historic cost accounting
• accounting policy
• window dressing
• creative accounting