The Limitations of Financial Ratios

Financial ratios provide valuable insights into a company’s performance, efficiency and future growth prospects. However, when analyzing a stock you must keep certain things in mind before interpreting these ratios. Ratios cannot be interpreted in isolation. They should be compared with industry averages and ratios of competitors in the industry. For example, a net profit margin of 10% may sound low, but it may be considered normal if the company is operating in the infrastructure industry. Similarly, ratios vary across industries. While a net profit margin of 12% may be outstanding for one type of industry, it may be considered as mediocre to poor for another.

 

Trend analysis of ratios can provide better insight into a company’s performance. However, it is important to be sure that the assumptions applied in calculating the ratios are constant throughout.

 

Some ratios include items from the Income Statement and Balance Sheet, such as Return on Assets, Inventory turnover and Receivable turnover. While the income statement reports performance over a specified period of time, the balance sheet provides a static measurement at a single point in time. This point must be considered while interpreting the results of ratio calculations. Year-end values in the Balance Sheet may not be representative. Values of certain items in the Balance Sheet may increase or decrease at the end of the accounting period due to seasonal factors, such as accounts receivables and inventories. These changes may distort the value of ratios. In these cases, it is more appropriate to use average values during the given period of time.

 

Comparisons of ratios with different industries would be meaningless. For example, comparing leverage ratios of stable utility companies with cyclical mining companies would be useless. Similarly, the comparison of a cyclical company’s profitability with a relatively stable company would fail to give an accurate long-term measurement of profitability.

 

Using historical financial data without understanding the fundamental changes in a company’s business strategy would predict very little about its future prospects. For example, the historical ratios of a company that has undergone a merger or had a substantial change in its technology or market position would tell very little about the prospects for this company.

 

Lastly, ratios are subject to the limitations of accounting methods. Any significant change in a ratio may also be due to changes in a company’s accounting techniques. As long as the accounting techniques remain more or less the same over time, meaningful inferences can be drawn by examining trends in financial ratios. Experience suggests that financial analysis works only if you are aware of accounting biases and makes adjustments for them.

 

Profitability Ratios
Asset Ratios
Liquidity Ratios
Financial Leverage Ratios
Valuation Ratios
The Limitations of Financial Ratios