What Are the Limitations of Using Ratio Analysis?
Financial ratio analysis is one of the most popular financial analysis techniques for companies and particularly small companies. Ratio analysis provides business owners with information on trends within their own company, often called trend or time-series analysis, and trends within their industry, called industry or cross-sectional analysis.
Financial ratio analysis is useless without comparisons. In doing industry analysis, most business use benchmark companies. Benchmark companies are those considered most accurate and most important and are those used for comparison regarding industry average ratios. Companies even benchmark different divisions of their company against the same division of other benchmark companies.
There are other financial analysis techniques to determine the financial health of their company besides ratio analysis. One example is a common size financial statement analysis. These techniques fill in the gaps left by the limitations of ratio analysis discussed below.
Benchmark to Industry Leaders' Ratios, Not Industry Averages
It may be contrary to everything you have ever learned. However, do you want high performance for your company? Or do you want average performance? All business owners should know the answer to that one. So benchmark your firm's financial ratios to those of high performing firms in your industry, and you will shoot for a higher goal.
As for a limitation of ratio analysis, the only limitation is if you use average ratios instead of the ratios of high-performance firms in your industry.
Companies' Balance Sheets Are Distorted By Inflation
Ever wonder why you always hear that balance sheets only show historical data? A balance sheet is a statement of a firm's financial condition at a point in time. So, looking back on a balance sheet, you see historical data. Inflation may have occurred since that data was gathered, and the figures may be distorted.
Reported values on balance sheets are often different from "real" values. Inflation affects inventory values and depreciation; profits are affected. If you try to compare balance sheet information from two different time periods and inflation has played a role, there may be distortion in your ratios.
Ratio Analysis Just Gives You Numbers, Not Causation Factors
You can calculate all the ratios you can find from now until doomsday. Unless you try to find the cause of the numbers you come up with, you are playing a useless game. Ratios are meaningless without comparison against trend data or industry data. Ratios are also meaningless unless you take the limitations listed in this article into account.
Different Divisions May Need Comparison to Different Industry Averages
Very large companies may be composed of different divisions manufacturing different products or offering different services. different industry averages need to be used for each different division to make ratio analysis mean something. The ratio analysis, used in this way, will certainly be more accurate than if you tried to do a ratio analysis for this type of large company.
Companies Choose Different Accounting Practices
Different companies may use different methods to value their inventory. If companies are compared that use different inventory valuation methods, the comparisons won't be accurate. Another issue is depreciation. Different companies use different depreciation methods. The use of different depreciation methods affects companies' financial statements differently and won't lead to valid comparisons.
Companies Can Use Window Dressing to Manipulate Their Financial Statements
Ratio analysis is based entirely on the data found in business firms' financial statements. Some companies may try to use window dressing to manipulate the data in the financial statements if they are not quite as good as they should be. Bear in mind — this is completely against the concept of financial and business ethics and flies in the face of corporate governance.
What exactly is window dressing? The company will perform some transaction at the end of its fiscal year. It will impact its financial statements making them look better, but is then taken care of as soon as the new fiscal year starts. That is the simplest form of window dressing. When ratio analysis is used with knowledge and not mechanically (just cranking out the numbers), it can be a very valuable tool for financial analysis for the business owner. Its limitations have to be kept in mind, but they should be more or less intuitive to a savvy business owner.
Read more about how to calculate a gearing ratio.