What are some potential pitfalls of ratio analysis based on accounting data?
Financial ratio analysis will rarely be useful if practiced mechanically. lt requires a large dose of good judgment. Financial ratios seldom provide answers, but they do help you ask the right questions. Moreover, accounting data do not necessarily reflect market values properly, and so must be used with caution. You need a benchmark for assessing a company’s financial position. Therefore, we typically compare financial ratios with the company’s ratios in earlier years and with the ratios of other firms in the same business. How do measures such as market value added and economic value added help to assess the firm’s performance? The ratio of the market value of the firm’s equity to its book value indicates how far the value of the shareholders’ investment exceeds the money that they have contributed. The difference between the market and book values is known as market value added and measures the number of dollars of value that the company has added. Managers often compare the company
