This paper is a critical analysis of two main issues, firstly, the limitations of ratio analysis and secondly the effect of credit crunch on the corporate sector. The purpose of this paper is to find out the inherent limitations of ratio analysis and how the corporate sector suffered a setback from the credit crunch which started from US and hit the world globally.
Question one [50 marks]
The financial ratios are ways of comparing and investigating the relationships between different pieces of financial information. Critically discuss the limitations of using the Financial Ratio Analysis.
Financial Ratios are ratios computed by the mangers to evaluate the performance, progress and achievements of the company with other companies in the same industry. Financial ratios also help the investors, creditors, lenders, analyst and managers in critically analysing an investment opportunity and credit decisions. The ratios compare the risk and return of a firm with that of other firms, thus ratio analysis support inter firm comparison. (Gerald I. White, Ashwinpaul C. Sondhi and Dov Fried, The Analysis and Use of Financial Statements, 3rd edn, Wiley, 2003 P.111).
A lot of research done in the past has shown that the performance of enterprises especially small and medium sized enterprises can be evaluated through the use of financial ratios. This report is aimed at showing the use of financial ratios is not the best method of evaluation performance of companies due to the inherent limitations of ratio analysis.
Drawbacks in using ratio analysis
When one uses the accounting and financial ratios as a method of assessing company's performance face the following problems:
Let's discuss each of the above problems separately
1 Loss making Companies
Even if a small limited company is incurring losses, it does not mean necessarily that the company is worthless, the owners of small business run the company for many other reasons other than just profit earning, for example “life style choice” (Jennings and Beaver, 1997; Jarvis et al., 2000; Green bank, 2001). Such small companies do not intend to grow into larger companies as they are working just to maintain their particular life style.
In the case of a public listed company, a loss may leave an adverse impact on its long term growth and investor, every company in order to survive in the long run need to be profitable (Reid and Smith, 2000). Financial ratio analysis is ineffective in the above case especially if one is trying to evaluate profitability because the ratio will be in negative due to loss.
2 No standard definition:
Financial ratios are calculated differently by using different formulas and definitions (Gibson and Cassar, 2005). For example if one wants to evaluate the profitability of any company he can use any of the following ratios:
The entire above ratios will give a different result; similar problem is experience while defining shareholders equity, debt, and long term loans etc. similarly some books lays down as the standard current ratio to be 1 but such conclusion are sometimes dangerous and misleading, some companies are able to perform well with a current ratio of less than 1, for example supermarkets.
Thus it can be concluded that ratio does not give comparable results and are not reliable, for example if while performing longitudinal ratio, the analyst changes from one definition to another and does not disclose the change in definition, then the new ratios cannot be compared with the earlier ones.
As seen above, when there is no standard definition of ratio, everybody can use different definitions according to their convenience; consequently the manipulation of ratios is easy. The management can choose any ratio, include or exclude any item and present such results which look better and remove any kind of distortion.
4 No supporting calculations and explanations
The annual reports of many companies does not show the calculations and definitions used in calculating ratios, this suppress the value of information they provide, as no supporting calculations are provided with the help of which clarity and genuineness can be established. In the case of small businesses also, where data are collected through self report mail surveys (Brush and Vanderwerf, 1992; Chandler and Hanks, 1993; Murphy et al., 1996) such figures are not consistent across business and hence incomparable.
5 Other unconsidered factors
Another disadvantage in using Ratio analysis as a performance assessment tool is that it does not take into account the things which cannot be measured in terms of ratio but otherwise have an impact on the value of the company by increasing sales indirectly, for example, the goodwill of the company in the market, change in management etc.
6 Time value of money
Ratio analysis fails to take into account factors such as rise in prices and inflation which affect the value of a dollar. For example, 10 years before a profit of $10 million might be a big achievement but today the value of 1$ is not the same as it was ten years ago. This limitation makes it difficult to compare historical figure with today’s figure, thus giving a distorted picture of the financial statements.
Source: Jane Frecknall- Hughes, Mike Simpson # and Jo Padmore, Inherent limitations in using financial ratio analysis to assess small and medium sized company performance., retrieved from, http://www.shef.ac.uk/content/1/c6/06/89/64/2007-01.pdf
An example establishing that ratio analysis leads to a distorted picture:
ABC is a plastic manufacturing company the CEO of the company to earn more profits is thinking of investing in a new business opportunity involving huge capital expenditure, the manager has calculated the ratio, “Internal Rate of Return (IRR)” of the Project and recommended that project is viable and the company should undertake it. A consulting firm suggested ABC that the use of IRR ratio is not the right method of judging the proposal because this ratio does not take into account the concept of “time value of money” and should not be used as a project evaluation tool. The management then changed the method and used NPV method of evaluation, it found out that the project was giving negative NPV hence should not be undertaken.
Inspite of these inherent flaws in ratio analysis it is still widely used by the marketing and operations management to evaluate the performance of the companies. As ratio analysis is not standardized, no supporting calculations and explanations are provided and no consideration is paid to the time value of money, there is a need for such a performance evaluation too, which takes into account not only the financial but also the non financial factors before judging the performance irrespective of the year under consideration.
Inspite of these big problems, organizations use ROCE and ROI and other ratios to judge the improvement in the performance of the organization (Meyer, 2005). Thus it is suggested that such work should be viewed carefully and cautiously when analysing the success and performance of a small medium enterprise.
Question two [50 marks]
Critically discuss the Credit Crunch and its effect on the Corporate Sector?
Credit crunch is defined as “A sudden reduction in the availability of loans and other types of credit from banks and capital markets at given interest rates. The reduced availability of credit can result from many factors, including an increased perception of risk on the part of lenders, an imposition of credit controls, or a sharp restriction of the money supply.
Slang for a general economic condition in which loans are harder to obtain. (Teach Me Finance.com)
The year 2008 saw a major global economic recession. While the signs of slowdown began to surface in US since the second quarter of 2008, it was the going down of Lehman Brothers in September 2008 that the entire world economic system went into disarray. It is widely believed that the genesis of the slowdown was the excessive use of credit default swaps in the US housing market which helped rise of toxic security. Since the US banks had lent excessively in the housing sector, it resulted in the prices going up to unrealistic levels. As a result when the markets started tumbling down, many banks found huge loan defaults. This impacted the liquidity in the system as banks stopped lending completely throwing the economy out of gear. Since there was no capital requirement on credit default swaps, the banks found that they are excessively leveraged when the derivatives went into losses. This impacted the solvency of many financial institutions such as Lehman Brothers, which in turn resulted into a major global economic recession. The banks stopped lending to each other as they grappled with the extraordinary situations and feared a lot of large financial institutions would go down under. This created a Credit Crunch – and all types of lending virtually stopped bringing the whole economy into a grinding halt.
The economic recession started from united states which experience a major rise in unemployment levels during the last ten years as can be seen from the data below: (data collected from www.Bls.gov): -
Source: Bureau of Labour Statistics
Graphically also, the unemployment rate in US has just doubled from 2004 to 2009:
The above figure shows the downfall in the GDP of US economy during the credit crunch.
Effect of Credit Crunch on Countries, US, UK and Europe
The Credit Crisis began in August 2007, when inter bank lending markets in the US, UK and Europe began to seize up. These markets had rarely received much public attention, and it was not immediately obvious why this should have happened. But loans on interbank markets, from overnight to several months, were not just important in keeping the flow of credit circulating amongst banks, and hence amongst almost all economic agents in a market system, they were made without collateral being necessary, and were increasingly important to the banking model developing across market economies. That model relied to an increasing extent on wholesale markets for supplies of capital, rather than on the deposits of individuals or companies. At the same time the degree of leveraging on capital was also increasing. So with larger supplies of credit and greater leveraging higher profits were possible. As were higher risks, as banks sought out increasing rates of return to satisfy their shareholders and those of their employees whose wages and bonuses were linked to levels of business or profits. But the increasing levels of risk seemed manageable by the device of securitisation, which appeared to allow the securitising bank to simultaneously sell on the risk and replenish its capital. When a rapidly deflating housing market bubble in the USA exposed weaknesses in this banking model, and similar bubbles in Ireland, the UK, Australia and Spain also began deflating, doubts about the location and value of securitised assets led eventually to an evaporation of trust between first banks, and then other financial and non-financial companies.
By the autumn of 2008 the lack of trust in the financial sector was sufficiently great to almost completely seize up credit flows and threaten the stability of the world financial system. The financial system was in effect broken, and by October 2008 a coordinated action by large numbers of central banks and countries was needed to stabilise it. This involved giving widespread promises of state protection to depositors, large injections of capital to banks, vast liquidity supplies to gummed-up financial market and increasing guarantees for all sorts of short term bond issues. Most recently the Crisis moved into the realm of sovereign default, as countries such Hungary and Ukraine struggle to refinance foreign currency loans, bringing in international agencies such as the IMF and the World Bank to provide assistance. At the same time the Credit Crisis has spawned an international economic downturn, and in some cases recession, the depth and severity of which cannot at the moment be estimated.
Source: International Monetary Fund “Global Financial Stability Report: October 2008”. Washington, IMF.
Non financial impact of Credit CrunchThe credit crunch had a very strong influence on the corporate sector; it impacted all firms over the world irrespective of their size, sector or location. According to a survey by Deloitte 58% of the CFO expect a negative effect of the credit crunch. According to Ian Stewart, associate director of Deloitte Research, said: 'CFOs are saying that the effects of the credit crunch have fed through the banking system and are affecting the corporate sector. Events in credit markets seem to be beginning to reshape strategic and funding plans of corporate, and in particular, their attitudes to debt.' The credit crunch impacted the corporate sector in the following ways: -
Source: US economy: the causes and Effects of a credit crunch, retrieved from http://www.associatedcontent.com/article/1022404/united_states_economy_the_causes_and.html
Source: The impact of Global financial crisis, http://siteresources.worldbank.org/TURKEYEXTN/Resources/361711-1216301653427/5218036-1261150457319/Survey.pdf
In short we can say that all businesses were hugely impacted both from the demand and supply side due to the severe credit crunch seen in 2008-09. It was only due to some swift action from The Governments and Central Bank of various key economies, viz – quantitative easing, lowering of interest rates, confidence building measures, support to weaker financial institutions, that the damage could be curtailed and the economy put back on the path of recovery. The recovery was also helped by the fact that no other large financial institution after Lehman Brothers was allowed to fail – the Government stepped in and infused equity into a lot weaker firms so as to keep the economy going. Simultaneously the authorities also took various monetary and fiscal measures to induce more money and thereby more demand into the economy. While this has resulted in halting the economic downfall, the challenge now would be to sustain the economic recovery while consolidating the fiscal deficits.
After analysing the above two questions, I reached to a conclusion that Ratio analysis should not be regarded as a sole reliable tool to assess the performance of a company due to the inherent limitation of standardization and confusion. Ratio analysis though a good way to understand changes cannot be regarded as an effective method in comparing results.
Credit crunch on the other hand had spread like a highly contagious virus; not only the sub-prime mortgages but the whole of the industries in the world are affected. I completely agree to the fact that credit crunch hit the world not only financially but also in non financial matters. The Credit Crisis has led to unprecedented government involvement in the financial systems of the advanced market economies, and that this poses significantly increased risks to public finances.