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Problems in Accounting Ratios

Original post by Ben Taylor of Demand Media

Accounting ratios for data such as liquidity, asset-turnover, financial leverage, profitability and dividends condense a range of financial information to create a picture of a firm's financial position. Such condensation is not without its limitations and problems, however. Ratios show a correlation between data sets without establishing causation for it; some ratios are also comprised of limited information. Assets, for example, typically are not reported at their current value on a company's balance sheet -- some assets may be omitted altogether, according to the Accounting Coach website.

Correlation Without Cause

Ratios represent the value of one quantity relative to another. The debt ratio, for example, is a financial leverage ratio that contextualizes a firm's indebtedness using its total assets, according to the Net MBA website. Because it only represents the monetary concerns regarding debt and assets, the debt ratio alone does not represent how the company arrived at that position. The ratio represents the firm's debt as a percentage, but does not provide information regarding how or why the firm is positioned as it is.

Limited Information

Some ratios are computed using limited information. Accounting ratios are comprised of data reported on a firm's financial statements -- its balance sheet, income statement, cash flow statement and statement of shareholder equity. Ratios computed using the assets reported on a firm's balance sheet, such as its current -- or working capital -- ratio, will only include assets that were acquired as part of a transaction, according to the Accounting Coach website. Such a stipulation means ratios involving a firm's assets will not include intangible assets, such as a creative or management team's innate value.

Contextual Constraints

Several ratios from multiple periods of time are necessary to create a meaningful representation of a firm's financial position. A single accounting ratio only represents a condensation of data for one period of time, such as a financial quarter; such a valuation isn't highly meaningful, according to the Net MBA website. The inventory turnover ratio, for example, measures the value of a firm's inventory by dividing the cost of goods sold by the average inventory for the time period, according to the Net MBA website. Historical ratios provide context, which will help determine whether the ratio represents normal, expected activity or a significant change in inventory activity.

Varying Opinions of Importance

The importance of one ratio may vary from company to company or sector to sector, depending upon the sort of business each conducts. Though ratios standardize data into objective percentages, they are limited in their ability to objectively represent the value and operations of a company. Asset turnover ratios might effectively represent the position of a firm with substantial inventory, for example, but would be less effective in representing a firm that is not heavily involved in physical sales.

                   

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About the Author

Ben Taylor has been writing since 2005 and has had work published by WEKU-FM and West Virginia Public Broadcasting both on air and online. Taylor holds a Master of Arts in English from Eastern Kentucky University and currently teaches composition and ESL there.

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