Ratio analysistransaction, or event, differently from another. This creates yet another problem for
the analyst when trying to use accounting information to make inter-business
comparisons.Other limitations of accounting ratios
Accounting ratios are derived by dividing one figure by another. As with all such indic-
ators, information is lost. A significant reason for using ratios is to enable comparison
to be made between factors that are not of the same scale. Sometimes, however, it is
important to be aware of scale. For example, the size of a business could double from
one year to the next, yet ratios alone would not reveal this fact.
It can be instructive just to look at the financial statements, trying to take a critical
and enquiring approach. For example, if we look back at Jackson plc’s balance sheet
for 2008, several points are worthy of note, none of which would be picked up from
using the standard accounting ratios.
The first of these relates to non-current assets, specifically to plant and machinery.
The depreciation provision, that is, that part of the cost that has already been treated
as an expense, is almost as large as the cost figure (£226 million compared with £253
million). This implies that the plant is coming close to the end of the life that was pre-
dicted for it by the business. This, in turn, has several implications:
l The business is operating with old plant. This may mean it is not using the most
sophisticated methods available to it. This may or may not be an important factor.
Nevertheless it is something that someone trying to make an assessment of the busi-
ness might find useful to know in building up the picture.
l Perhaps, more significantly, it seems likely that there will be a need to replace
various items of plant in the fairly near future. This will probably lead to a major
outflow of cash. This raises the question of where the cash will come from. Has the
business got the levels of cash required or will it need to borrow or to raise new
share capital?
l In a period of inflation, old non-current assets imply a low annual depreciation
expense charged in the income statement. Thus profits may be overstated relative
to that which would result if newer plant were to be used.
The next point relates to the reserves. It would be perfectly legal for the shareholders
to be paid a dividend of £209 million at 31 December 2008, perhaps selling some of the
non-cash assets to raise the necessary funds. This massive outflow of assets could have
disastrous effects on the business in terms of its ability to continue to trade. Although
this large dividend is not a likely outcome, the possibility is there and it should be
recognised.
A third point is that, according to the balance sheet, there is a reasonable amount
of scope for further secured borrowing. The loan notes are probably secured on the
freehold land. The freehold land is probably understated on the balance sheet in terms
of its market value. This could mean that the business would be able to double
the amount of its secured borrowings. Since it is very much easier to borrow when the
security of an asset, such as land, can be offered, this might be a significant point.
Perhaps the business does not want to raise further loan capital. Perhaps there are
separate reasons why it would find it difficult to borrow. On the other hand, the point
about unused security might be an important one.
Similar points could be identified by further careful scrutiny of the financial state-
ments, without even bothering to calculate any ratios.