Ratio analysis, without a doubt, is amongst the most powerful tools
of financial analysis. Any investor, who wants to be more efficient at
their job, must devote more time towards understanding ratios and ratio
analysis. However, this does not mean that it is free of limitations. Like
all techniques, financial ratios have their limitations too.
Understanding the limitations will help investors understand the
possible shortcomings with ratios and avoid them. Here are the shortcomings:
Misleading Financial Statements
The first and foremost threat to ratio analysis is deliberate
misleading statements issued by the management. The management of most
companies is aware that investors look at certain numbers like sales,
earnings, cash flow etc very seriously. Other numbers on the financial
statements do not get such attention. They therefore manipulate the
numbers within the legal framework to make important metrics look good.
This is a common practice amongst publically listed companies and is
called “Window Dressing”. Investors need to be aware of such window
dressing and must be careful in calculating and interpreting ratios
based on these numbers.
Incomparability
Comparison is the crux of ratio analysis. Once ratios have been
calculated, they need to be compared with other companies or over time.
However, many times companies have accounting policies that do not match
with each other. This makes it impossible to have any meaningful ratio
analysis. Regulators all over the world are striving to make financial
statements standardized. However in many cases, companies can still
choose accounting policies which will make their statements
incomparable.
Qualitative Factors
Comparison over time is another important technique used in ratio
analysis. It is called horizontal analysis. However, many times
comparison over time is meaningless because of inflation. Two companies
may be using the same machine with the same efficiency but one will have
a better ratio because it bought the machine earlier at a low price.
Also, since the machine was purchased earlier, it may be closer to
impairment. But the ratio does not reflect this.
Subjective Interpretation
Financial ratios are established “thumb of rules” about the way a
business should operate. However some of these rules of thumb have
become obsolete. Therefore when companies come with a new kind of
business model, ratios show that the company is not a good investment.
In reality the company is just “unconventional”. Many may even call
these companies innovative. Ratio analysis of such companies does not
provide meaningful information. Investors must look further to make
their decisions.
