Limitations of Financial Ratios
There are some important limitations of financial ratios that analysts should be conscious of:
- Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios. - Inflation may have badly distorted a company's balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment. - Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the back-to-school season. As a result, the company's accounts payable will be high and its ROA low. - Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.). - It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations. - A company may have some good and some bad ratios, making it difficult to tell if it's a good or weak company.
In general, ratio analysis conducted in a mechanical, unthinking manner is dangerous. On the other hand, if used intelligently, ratio analysis can provide insightful information. Financial ratios are not very useful on a stand-alone basis; they must be benchmarked against something. Analysts compare ratios against the following:
1.The Industry norm – This is the most common type of comparison. Analysts will typically look for companies within the same industry and develop an industry average, which they will compare to the company they are evaluating. Ratios per...
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