Financial Ratios

Financial ratios are useful indicators of a firm's performance and financial sit
uation. Most ratios can be calculated from information provided by the financial
statements. Financial ratios can be used to analyze trends and to compare the f
irm's financials to those of other firms. In some cases, ratio analysis can pred
ict future bankruptcy.
Four Basic Types of Financial Ratios Used to Measure a Company's Performance
Ratios can be divided into four major categories:
Liquidity
Solvency / Leverage (Funding
Debt, Equity, Grants)
Profitability Sustainability
Operational Efficiency
What are the limitations of financial ratio analysis ?
Limitations:
Despite usefulness, financial ratio analysis has some disadvantages. Some key de
merits of financial ratio analysis are:
1.
Different companies operate in different industries each having differen
t environmental conditions such as regulation, market structure, etc. Such facto
rs are so significant that a comparison of two companies from different industri
es might be misleading.
2.
Financial accounting information is affected by estimates and assumption
s. Accounting standards allow different accounting policies, which impairs compa
rability and hence ratio analysis is less useful in such situations.
3.
Ratio analysis explains relationships between past information while use
rs are more concerned about current and future information.
Here are some limitations of ratios that all analysts must be aware of:
1.
Ratios are only as informative as the financial statements on which they
are based. If the underlying accounting is suspect, then the ratios will be su
spect. Ratios are sensitive to changes in accounting assumptions and to window d
ressing techniques that organizations use to make their financial results look be
tter. Furthermore, ratios are not very useful in detecting fraud (or unintentio
nal mistakes) in the accounting system.
2.
Ratio analysis is probably most accurate for organizations with a narrow
line of products or services. The more complicated the organization becomes, t
he more difficult a good ratio analysis is.
3.
Inflation can distort the financial statements (particularly the balance
sheet). Any problem in the financials caused by inflation can be passed on to
ratios.
4.
With some ratios it is difficult to tell where a ratio value changes fro
m good to bad. For example: How much liquidity is enough? How much is too much?
5.
It is sometimes very difficult to draw overall conclusions about an orga
nization using ratios alone. Some ratios may be very good, while others are not
very good. There is no clear and systematic way to sift all of the ratio infor
mation into a single conclusion about an organization s overall health and perform
ance.
6.
Differences in accounting assumptions may make it difficult to compare r
atios from different organizations. Accounting assumptions can include inventory
methods such as last-in, first-out [LIFO] or first-in, first-out [FIFO] and dep
reciation methods like Straight Line or Double Declining Balance.
7.
Differences in ratio definitions may make it difficult to compare ratios
from different sources. There can be many different ways to compute the same ra
tio. This can cause confusion or different answers for the same ratio name.