While you are observing financial ratios in your exploration, or fundamental analysis of a security to reach a decision to buy or reject, keep in mind the potential for these limitations of financial ratios.
Limitations of Financial Ratios
Financial ratios provide valuable insight into a company’s performance, efficiency and future growth prospects. However, limitations of financial ratios can exist when analyzing a stock, you must keep certain things in mind before interpreting these ratios. These ratios cannot be interpreted in isolation. Alternatively 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. This shows that limitations of financial ratios can exist.
Comparisons of ratios with different industries would be meaningless, another example of the limitations of financial ratios. 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. This information has hopefully helped you understand the limitations of financial ratios.