Ratios Are Misleading and Have Many Limitations

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Ratios are Misleading and Have Many Limitations

Ratios give us a glimpse of a company’s performance against other companies in the industry but these ratios characteristics (good or bad) may not be as good or bad when one measures them against their peers. Why? Ratios are a snap shot taken at a point in time, so over the course of ones business cycle there is expansion and contraction of sales and profitability, so ratio analysis taken for any one year might not present the full picture of how the firm is really performing. To insure that one is receiving the full picture one would implement a trend analysis of a company’s performance over a number of years.

With regard to possible limitations of ratios, there are a number of possible distortions to ratios with regard to how accountants report on such items as effect of inflation (during inflationary times revenue is usually stated in current dollars, where plant and equipment or inventory could have been purchased at lower prices thus profit being more a function of price increases than that of increased performance), or disinflation, timing of recognition of sales as revenue, how the accountants treat inventory write offs, or the presence of extraordinary gains and losses and how these are reported to name a few. A financial analyst must take ratios and numerous other tools into play when evaluating the operating performance of a company against those achieved by similar companies in that industry. This can be another sticking point due to the fact that financial analysts might lack objectivity due to were they work, companies that not only provide financial analysis to investors but also underwrite the securities of the firms they are doing the analysis of such as Goldman Sachs doing research and financial analysis on GE while also profiting from investment banking business with GE.
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