The use of estimates, cost, alternative accounting methods, the presence of atypical data, and diversification of firms are all factors that may limit the usefulness of financial statement analysis. Identify a ratio and explain how one or more of the limiting factors can affect the usefulness of that ratio

Answer 1

Any of the profitability ratios that involve net income will be affected by the method of depreciation chosen. The use of an accelerated method, such as double-declining balance, will result in higher depreciation costs in the early years and lower depreciation costs in the later years. These costs will differ from the depreciation costs that would have been incurred if the straight-line method had been used. Therefore, because of the different costs, net income will also be different. Thus, the choice of depreciation method affects net income, which in turn affects the ratio.

Both the quick ratio and the receivables turnover ratio are affected by the estimate of uncollectible accounts. The estimate will determine the amount of net receivables used to calculate the ratio. A high estimate will lower the net receivables and a low estimate will increase the net receivables. Thus, the accuracy of the estimate will have a direct effect on the accuracy of the ratio.