About the Limitations of Financial Analysis Ratios

by Stephanie Powers ; Updated July 27, 2017

Numbers don’t lie. But, sometimes they bend the truth. Financial analysis ratios can provide valuable information, but they must be interpreted carefully.

Function

Financial analysis ratios are commonly used by investment analysts, investors, economists, loan analysts, and others to assess the financial health of organizations. They provide a common point of comparison to benchmarks to evaluate financial health and performance. Economic models are built around historic financial analysis ratios. Firm managers are often evaluated based on their contribution to the company using financial ratios.

Types

Some of the most common types of financial analysis ratios: Return on Equity--Measures performance and should be considered with leverage ratios. Asset Utilization Ratios--Measures efficiency and is highly industry dependent. Liquidity Ratios--Risk assessments are industry dependent. Market Price ratios--Valuation must consider growth opportunities.

Time Frame

Trend analysis compares a company’s ratios over time. Careful interpretation of the trend requires knowledge of management changes, industry changes, the overall state of the economy during the given time period, and any other issues that may have impact. Industry ratios change with the lifecycle of the industry. For example, as cell phone use peaked, inventory turnover showed steady dramatic increases. Once the market became saturated, inventory turnover leveled and increased at a slower rate.

Features

Financial ratios are compared to benchmarks to determine whether they are good are bad. The benchmarks change as the company moves through its business lifecycle. Benchmarks are often selected according to industry, but some firms are dramatically different than other firms in their industry. Common financial analysis industry ratio benchmarks are calculated by Dun & Bradstreet, Standard & Poor’s and the Risk Management Association. It is difficult to compare financial analysis ratios of companies because items on financial reports may be calculated differently. For example, calculating inventory using the first-in-first-out method (FIFO) vs. the last-in-first-out (LIFO) method impacts valuation ratios. Professional analysts are aware of the limitations of financial analysis ratios and adjust for them in their calculations. Generally Accepted Accounting Principles (GAAP) and International Accounting Standards (IAS) also acknowledge issues.

Considerations

Ratios are only as good as the data used to construct them. Sometimes financial statements are restated for various reasons. Sometimes organizations incorrectly report items. Financial statements often come with a list of ending notes which must be carefully scrutinized. Adjustments to figures may be made before calculating ratios. Companies know the importance of financial ratios on their company and use them as metrics in running the business. Individual ratios viewed in isolation may produce inaccurate assessments. For example, when comparing two similar firms with the same Return on Assets (ROA), the firm with lower debt will have better Return on Equity (ROE). Analyzing multiple ratios is a more complex process, but produces more accurate information. The past does not always predict the future.

About the Author

Stephanie Powers has been a professional writer since 2007. She honed her research and writing skills as a business and financial consultant. Her writing specialties include Web content, blogs, newsletters, professional journal articles and white papers. She has an undergraduate degree in business from Drake University and a Master of Business Administration from Houston Baptist University.