Question

As an accountant who frequently prepares financial statements for firms, Hina is well-aware of the concept of the financial ratio. Which of the following is correct regarding a financial ratio?

O It is a number that shows the relationship between three or more elements of a firm's financial statements.
O Although it can be compared with a firm's past ratios from previous accounting periods, it cannot be accurately or effectively compared with the ratios of competitors, or with industry averages.
O The information required to form a financial ratio can be found in a firm's balance sheet, income statement, and statement of cash flows.
O Although it can accurately and effectively measure a firm's profitability and how often it sells its inventory, it cannot measure a firm's ability to pay its debts.

Answer 1

A financial ratio shows the relationship between two elements of a firm's financial statements, can be used for comparisons with industry and historical data, and can measure aspects including profitability and debt payment ability. The four-firm concentration ratio and Herfindahl-Hirschman Index provide insights into market competition, but each has limitations in fully capturing market dynamics.

Step-by-step explanation:

Regarding the correct statement about a financial ratio, it is indeed a number that shows the relationship between two or more elements of a firm's financial statements, not three or more as incorrectly suggested in one of the options.

These ratios can be compared with a firm's past ratios from previous accounting periods and also with the ratios of competitors, as well as with industry averages, contrary to the statement provided in the question. Furthermore, the information required to calculate a financial ratio can indeed be found in a firm's balance sheet, income statement, and statement of cash flows. Additionally, financial ratios can measure a firm's profitability, frequency of inventory sales, and its ability to pay debts, again contrary to the incorrect option provided.

The concepts of the four-firm concentration ratio and the Herfindahl-Hirschman Index (HHI) are used to measure the extent of competition in a market. The four-firm concentration ratio adds the market shares of the four largest firms in the market, while the HHI takes the market shares of all firms, squares them, and sums the total. Although both of these tools provide insights into market competition, they may not fully capture the nuances of market dynamics, such as the distribution of market shares among firms.