Question

RNA Inc. manufactures a variety of consumer products. The company’s founders have run the company for 30 years and are now interested in retiring. Consequently, they are seeking a purchaser who will continue its operations, and a group of investors, Morgan Inc., is looking into the acquisition of RNA. To evaluate its financial stability and operating efficiency, RNA was requested to provide the latest financial statements and selected financial ratios. Summary information provided by RNA is as follows.

RNA INC. INCOME STATEMENT FOR THE YEAR ENDED NOVEMBER 30, 2018 (IN THOUSANDS)
Sales (net)	\(30,500
Interest income	500
Total revenue	31,000
Costs and expenses
Cost of goods sold	17,600
Selling and administrative expenses	3,550
Depreciation and amortization expense	1,890
Interest expense	900
Total costs and expenses	23,940
Income before taxes	7,060
Income taxes	2,800
Net income	\) 4,260

RNA INC. BALANCE SHEET AS OF NOVEMBER 30 (IN THOUSANDS)
	2018	2017
Cash	\( 400	\) 500
Short-term investments (at cost)	300	200
Accounts receivable (net)	3,200	2,900
Inventory	6,000	5,400
Total current assets	9,900	9,000
Property, plant, & equipment (net)	7,100	7,000
Total assets	\(17,000	\)16,000
Accounts payable	\( 3,700	\) 3,400
Income taxes payable	900	800
Accrued expenses	1,700	1,400
Total current liabilities	6,300	5,600
Long-term debt	2,000	1,800
Total liabilities	8,300	7,400
Common stock (\(1 par value)	2,700	2,700
Paid-in capital in excess of par	1,000	1,000
Retained earnings	5,000	4,900
Total stockholders’ equity	8,700	8,600
Total liabilities and stockholders’ equity	\)17,000	$16,000

SELECTED FINANCIAL RATIOS
RNA INC
	2017	2016	Current Inventory Average
Current ratio	1.61	1.62	1.63
Acid-test ratio	0.64	0.63	0.68
Times interest earned	8.55	8.50	8.45
Profit margin on sales	13.2%	12.1%	13.0%
Asset turnover	1.84	1.83	1.84
Inventory turnover	3.17	3.21	3.18

Instructions

(c) Identify two limitations of ratio analysis.

Short answer

The ratio analysis approach is a highly effective tool for analyzing a company's financial position. However, it has important limitations that should not be overlooked when conducting such an analysis.

Step-by-step solution

Meaning of Ratio Analysis

The comparison of a company's ratios to the industry's benchmark businesses is known as ratio analysis. Because it gives substantial insights from the financial statements, this form of financial research may be valuable to both internal management and external analysts of the organization.

Identifying limitations of ratio analysis

Ratio analysis has several drawbacks, including:

1. With accounting discrepancies, it is difficult to compare companies in the same industry. Straight-line versus accelerated depreciation, LIFO versus FIFO, and other accounting systems can provide different results.
2. The information contained in financial statements is used to calculate ratios. Financial accounts, on the other hand, involve a variety of limitations that can affect the accuracy of ratio analysis.