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IAI Actuarial Core Principles · Business Finance · Interpreting company accounting information

A company's year-end balance sheet shows very low receivables and inventory because it ran a heavy discount campaign in the final month, selling off stock and collecting cash quickly. Which limitation of ratio analysis does this best illustrate when the year-end current ratio is used to assess liquidity?

This illustrates that year-end balance sheet figures are a snapshot and may not represent the position during the year. Seasonality or window dressing, such as a last-month clearance sale, can distort ratios like the current ratio and mislead users.

  1. ARatios use only forecast data, never historic data
  2. BYear-end figures may not be representative of the position during the year, because of seasonal or window-dressing effectsCorrect
  3. CRatios cannot be calculated when sales exceed purchases
  4. DRatios are unaffected by timing, so the result is reliable
  5. Ratios always overstate profitability

Explanation

A balance sheet is a snapshot on one date. Unusual actions or seasonality around the year end can make the ratios unrepresentative of typical conditions, so conclusions drawn from a single date may mislead.

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