What Are Limitations an Investor Should Consider When Performing a Ratio Analysis?
Original post by Austin Berry of Demand Media
Financial ratio analysis divides and compares numbers to arrive at percentages, and investors use the ratios to assess key financial data such as profitability and liquidity. However, in their objectification of business finances, financial ratios guarantee neither scientific accuracy nor comprehensive analysis. This is because results garnered from ratio analysis focus only on specific aspects of business performance and are based on changeable methods of quantification, such as different ways of valuating assets.
Results of the same ratios using different variables can lead investors to different conclusions. For example, the current ratio will not be the same depending on whether assets are valued using mark to market or fair value appraisals, the latter of which is subject to estimation. Ratios are also limited because they leave out important firsthand knowledge of managerial and operational practices.
Timing of financial records and estimates greatly influence ratio results. If a business sells inventory and subsequently pays off debt prior to a financial statement cut off date, it will positively affect competitive positioning in terms of the return-on-assets ratio and debt-to-assets ratio, even if a second company sells twice as much just a few days later. Similarly, ratios based on past rather than future earnings estimates also show different financial scenarios.
How businesses utilize capital across international boundaries can also limit the effectiveness of ratio analysis. A study in the "International Journal of Business Accounting and Finance" attributes this limitation to differences in financing methods. Moreover, the research demonstrated Chinese companies are more reliant on short-term debt liabilities as a means of financing than similar U.S. companies. Such being the case, the former company would show weaker liquidity despite being more financially stable than the latter, if the analysis emphasizes short-term liquidity metrics such as the cash ratio.
Accounting methods also limit the capacity of ratio analysis by allowing for misrepresentation of a business' financial strength. To illustrate, International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) have for a time, both used different rules regarding the valuation of goodwill, and the recording of assets and debt. For example, both IFRS and GAAP require damaged assets to be revised, however due to different methods of calculation, the actual bookkeeping results used in financial ratios can differ.
Since financial ratios are numerical measurements, they do not represent a number of other factors relevant to business assessment. For example, neither the legal and regulatory environment, nor business culture are qualitatively expressed via financial ratio analysis. Moreover, financial ratios cannot tell an analyst how much corporate culture influences the usefulness of marketing campaigners, or the prospect of increased market share arsing from this. In this sense, the scope of financial ratios are limited by reliance on numerical focal points that target specific financial fundamentals of a business.
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About the Author
Austin Berry has five years' experience in online, contractual and academic writing. He has been published at HomeownersInsurance.org and TaxBox.org. He holds a Master of Business Administration in finance and marketing from the University of Missouri, and a Master of Arts and Bachelor of Arts with concentrations in the philosophy of science and philosophy from George Mason University.
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