Financial ratio analysis is perhaps the oldest and most essential tool used to evaluate a company’s credit position and overall financial performance. Financial statements of a company generate a large number of ratios which analysts use depending on the company’s activity or purpose of analysis. Although the application of ratio analysis is widespread, it poses inherent limitations. The article outlines the ratio groups and the benefits of ratio analysis and explores its limitations to decide if financial ratio analysis is an effective tool.
Financial Ratios
Most analysts classify ratios into four groups: liquidity, activity, debt, and profitability ratios.
Liquidity ratios: They assess a company’s ability to repay its short-term debt. Current ratios involving current assets and current liabilities form part of liquidity ratios.
Activity ratios: They measure the company’s ability to convert its balance sheet accounts into cash. The values assess the efficiency of the company. Ratios in this group include inventory turnover, assets turnover, etc.
Debt ratios: They assess a company’s leverage levels and consequent potential risks. Ratios in this group include debt-equity, debt-assets, interest margin, etc.
Profitability ratios: They measure a company’s performance in terms of its ability to generate revenues. Ratios in this group include ROA, ROI, net profit margin, etc.
Benefits of Ratio Analysis
Simple and straightforward – It is easy to calculate ratios and arrive at useful information at an instant. Calculating the ratios involves the straightforward use of the numbers from a company’s financial statements.
Comparisons – It is possible to compare ratios over different time periods, companies, and industry. Ability to compare provides information and analysis on trends within the company and the industry. Such comparisons also provide information for decisions on financial goals and critical to success factors.
Forecasting – Companies analyze ratios to forecast decisions on expansions. For example, companies will forecast the costs of future projects depending on their ability to pay off short-term obligations. Liquidity ratios assess the ability.
Discipline – Profitability ratios, which evaluate a company’s performance also implies the evaluation of its managers’ performances. An indirect result of the ratios is making the managers adhere to the financial goals and thus, discipline them.
Limitations of Ratio Analysis
For many years, analysts have been using ratio analysis as the established technique to analyze, compare and forecast company performances. However, even such established methods have inherent limitations.
- Accounting policies: Accounting laws allow companies to choose accounting policies and use discretion while preparing accounts. Such a freedom leads to differences in the accounts of companies, which in turn distorts inter company comparisons. (LIFO versus FIFO, purchasing equipment versus leasing, etc)
- Outdated information: Financial statements have outdated figures. Hence, they do not indicate a company’s current position. Moreover, the balance sheet, which is a snapshot of a company’s financial position at a particular time, will not capture it for the whole year. If a company has a seasonal business wherein the year-end coincides with a low business activity, the balance sheet may present a low figure on stocks and debtors.
- Creative accounting: Companies tend to present inflated revenues and reduced liabilities on the financial statements. In particular, they tend to window dress during earnings results seasons. These tricks make investors believe that companies have a strong financial position. However, such creative accounting misleads analysts using financial accounting and ratios.
- Interpreting ratios: Although there are standard rules for interpreting ratios, analysis is not complete without following a deeper understanding on how to interpret ratios. For example, interpreting a high liquidity ratio as positive is common as it signifies the ability of a company to pay its short-term debts. However, the company loses out on the opportunity cost of hoarding excessive cash. If put to productive use or investments, the cash pile will provide better yields. Similarly, it is possible to interpret a high debt ratio as loans used for growth or loans used inefficiently and thus, unable to repay.
- Inflation: Inflation distorts performance comparisons. A comparison of financial results over time is misleading as the figures are not directly comparable. The income statement may present increased revenues and net profit indicating improvement in financial performance. However, inflation and not improved sales may have boosted the financial figures.
- Different risk profiles: Companies have different financial and market risk profiles. Differences in types of market, competitive intensity, and governmental interference cause the difference in risk profiles. Companies in the same industry also face different financial and market risks. Comparing using ratios may mislead the inferences about them. For example, a company with a low debt ratio may indicate improved financial position. However, banks may not have provided loans to the company owing to the company’s low creditworthiness or high financial risk profiling. Another company in the same industry may have a low financial risk profiling, and it may obtain loans at a reduced rate for expansions. But, the financial statement will only show a high gearing rate. In this case, ratio analysis leads to incorrect interpretations and conclusions about both the companies.
- Benchmarking: The benchmark for a company’s financial ratios is its industry averages. In order to ensure high performance for a company, it is necessary to change the process of benchmarking with the industry averages to industry leaders.
- Company divisions: Large companies operate many divisions in different industries. Difficulty in finding suitable industry averages for ratio analysis arises due to such differences.
- Qualitative factors: Ratio analysis does not consider qualitative factors. Management quality, donations, charities and goodwill do not find a quantitative measure to include in financial analysis.
Ratio analysis depends on accounting and not economic data. It is retrospective and not prospective examination. There is ample proof that a company’s stock price movement correlates closely with cash flow measure and not income based measures.
Do the limitations outweigh benefits? They certainly do. However, financial ratio analysis is still a tool useful in assessing a company’s financial performance. Although not an adequate method, ratios can provide a functional understanding of a company’s operations, if used intelligently. It is necessary to consider external influences on the financial tool and realize the potential for distortions. Analysts need to understand the limitations in the analytical method and make the necessary modifications.
