IAI Actuarial Core Principles · Business Finance · Interpreting company accounting information
A financial analyst compares the current ratio of an Indian cement manufacturer with that of an Indian software services company and concludes the cement firm is poorly managed because its ratio is lower. Which limitation of ratio analysis is most directly illustrated by this conclusion?
The conclusion shows that ratios mislead when firms from different industries are compared. Cement and software businesses have different asset structures and working capital needs, so their normal ratio levels differ, and a lower ratio alone does not prove poor management.
- ARatios are calculated only from audited figures, so they are always reliable
- BRatios can be misleading when firms in different industries with different operating structures are comparedCorrect
- CRatios cannot be computed when a company has long-term borrowings
- DRatios always ignore the balance sheet and use only the income statement
- Ratios are distorted only by changes in the income tax rate
Explanation
Different industries have different norms for working capital, asset intensity and financing. A low current ratio may be normal for one sector and weak in another, so cross-industry comparison is misleading. The other options are false statements about how ratios are calculated.
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