Ratio analysis is a tool to analyze the financial performance of a business. It offers some advantages and disadvantages.
Analysts must be aware of the potential limitations of ratio analysis. By understanding these limitations, analysts can make adjustments to evaluate the financial performance of a business that is closer to reality.
What is Ratio Analysis?
Ratio analysis is the quantitative method of analyzing line items of the financial statements of a company.
It uses data available from the financial statements of the business. It analyzes different metrics of different financial statements by comparing two or more line items.
Ratio analysis is the basic form of fundamental analysis. It is mainly used by investors and external stakeholders of a business. It uses the historic (periodic) financial data of a business to compare different terms.
Ratio analysis is an important tool to analyze the financial strength of a business. It is mainly used to determine the trend lines of different performance metrics of a business.
Categories of Ratio Analysis
Ratio analysis can be performed for various types of financial metrics. These ratios can be grouped into a few broader categories.
These ratios provide information about the abilities of a business to generate profits using its resources.
Common profitability ratios include gross profit, net profit, ROI, ROCE, ROA, etc.
Liquidity ratios analyze the debt servicing abilities of a business using its current assets. These ratios include cash ratio, quick ratio, and current ratio.
Solvency ratios compare the long-term liabilities of a business against its long-term assets, equity, or retained earnings.
These ratios include capital ratio, debt ratio, interest coverage ratio, etc.
Efficiency ratios show how well a business utilizes its assets and liabilities to generate sales and earn profits. These are also called activity ratios.
These ratios include asset turnover ratio, inventory turnover, working capital turnover, and so on.
These ratios are particularly related to the ability of a business to repay its debts. These debts can be short-term or long-term.
Common coverage ratios include debt coverage, interest coverage, EBTIDA coverage ratios, and so on.
Limitations of Ratio Analysis
Ratio analysis is widely used by managers and investors to analyze the financial performance of a business. This analysis can be used to appraise the historic performance of a business and comparison against historic results.
Ratio analysis is also a useful tool for benchmarking against industry trends. However, it comes with many assumptions and pitfalls.
Here are a few major limitations of ratio analysis.
Use of Historic Data
The biggest limitation of ratio analysis is its use of historic data. Ratios use data from the financial statements of a business.
Even when an analyst uses recently prepared financial statements, they will be outdated to some extent.
Financial statements also use historic data for the transactions that have occurred in the past. It means the most recent transactions would soon be historic.
Therefore, any analysis derived from such historic data will require some assumptions. It also implies that analysts can use historic data to predict the future performance of the business without providing the context.
Inconsistent Adjustments for Inflation
Businesses always need to account for the inflation effects. Inflation affects all types of financial metrics including costs, interest rates, NPV analysis, profits, forecasts, and so on.
Therefore, inflation would distort the historic data. The figures previously used would then be required for inflation adjustments.
Inflation effects need to be adjusted whenever it occurs between the periodic statements of a business are available. Figures previously used would be adjusted for inflation to reflect actual data.
It will be particularly important when using ratios directly affected by inflation like interest coverage, profit margins, debt coverage, etc.
Affected by Accounting Policies
Another limitation of using historic data is that analysts would need to consider any changes in the accounting policies of a business after using these figures.
For example, a company may decide to use the double-line accelerated depreciation method instead of the single-line conservative depreciation method. Similarly, a company’s leasing policy, dividend policy, or any other significant change would alter the ratio analysis.
Such accounting changes would affect the key performance metrics of a company. Therefore, analysts must consider such changes before making any conclusions.
Businesses announce such accounting policy changes through notes to financial statements sections. So, analysts must account for such changes to make comparisons using previously published data.
Seasonal effects are particularly important for cyclic businesses. These businesses would show uneven and inconsistent financial performance metrics during different seasons.
Normal businesses also go through seasonal effects of sales, profits, and growth. Ratios using these seasonal figures may not offer the full information to analysts.
It is up to the analyst to interpret and consider these seasonal distortions. These distortions can be positive or negative. Therefore, comparing the periodic results of a business requires careful attention.
Ignoring seasonal effects on a business may be misleading. Also, it will be unfair to compare a cyclic business with a non-cyclic business using ratio analysis.
Affected by Operational Changes
Along with accounting policies, a business may go through operational changes with a strategic shift.
Operational changes may include restructuring, changing lines of production, new product launches, employee layoffs, and so on.
All of these factors happening after publishing the financial statements would mean historic ratios would be meaningless.
Also, when a business goes through an operational change, its perspective of performance appraisal changes. Therefore, analysts must consider these factors when analyzing the previous performance of a business.
These changes will also make it difficult to forecast a business’s performance since its historic data will be out of context.
Manipulation of Data – Financial Statements
Business managers are always inclined towards achieving performance targets as their remunerations are tied with targets.
Often managers distort financial statements through window dressing. Many accounting policies are subject to the choices of business managers.
For example, choosing the type of depreciation, handling working capital, managing accounts payable/receivable, and so on.
There are various metrics that can be artificially adjusted in one accounting period. So, these figures will show boosted performance in one accounting period and come to the normal level in the following period.
Ratio analysis cannot detect such distortions and manipulations unless analysts perform due diligence.
Comparison Against Industry Leaders – Not Averages
One of the key benefits of ratio analysis is its use for benchmarking against industry trends. The same can be its disadvantage if taken out of context.
Many businesses make the mistake of comparing their performances with the industry leaders with the highest performing indicators.
However, ratio analysis must be used to compare the performance of a company with the industry averages rather than the top performers.
Also, such comparisons must consider the resources available to both companies being compared. The availability of resources, growth, and established history should be brought to context for these benchmarking comparisons.
Different stakeholders of a business may conclude different results albeit using the same available data. Particularly, the internal and external stakeholders of a business would be at odds more often.
It happens because ratio analysis needs to be interpreted by analysts. So, analysts would arguably interpret the financial performance of a business differently.
There are no set standards or rules to determine the ratio analysis too. For example, a gearing ratio of 80% for a business may be considered too risky by one analyst and quite normal by another.
Like other factors, analysts must dig deeper and perform due diligence to reach conclusions.
Ignores Qualitative Factors
Ratio analysis is quantitative in nature, it does not consider the qualitative side of the performance appraisals.
For example, an established business may go through a dry patch of sales that would significantly affect its financial performance temporarily.
Stakeholders and analysts should consider the fact that the same business can sustain such patches without going into trouble. Therefore, their prompt interpretations of the shortcomings would be inappropriate.
Similarly, a company’s financial performance can be boosted artificially using accounting adjustments, window dressing, and similar tactics.
Analysts must be careful about the interpretation of the financial performance of such businesses too. These analyses must consider the actual performance and sustainability of the business in the long run.
Does Not Help in Forecasting
Finally, historic data can only be used to appraise the financial performance of a business in its past.
Ratio analysis follows the historic context without offering insights into the future of a business. Thus, it will be unwise to use ratio analysis for forecasting without considering certain assumptions.
It’s not to say that ratio analysis is useless for forecasting. However, analysts must bring in the context, make adjustments, use qualitative factors, and then assign probabilities of future outcomes for a business.
Ratio analysis can be a useful starting point for analyzing the financial performance of a business. However, analysts must consider potential pitfalls and make adjustments to reflect the actual performance of a business.