By Chron Contributor Updated December 16, 2020
Financial ratios are used almost universally by companies of all sizes to provide numerical information on the profitability, health and direction of the business. Financial ratios provide useful analysis and can help drive management toward making better decisions if they are interpreted correctly. At face value, ratio analysis is the measure of strength and weakness of the firm, however, there are some drawbacks to relying on these metrics.
Lack of Comparability Between Companies
Financial ratios are a useful tool to track changes in business over time. For example, if a liquidity ratio is lower this year than last, there may be a problem that needs further investigation. However, ratios do a poor job at comparing one company with another, although they are often used that way.
Using ratios to compare two firms in the same industry may be difficult if, for example, a company uses a last-in-first-out valuation, its ratios that include inventory will be significantly different than a company that uses first-in-first-out. The ratios will not be comparable because the valuations are not comparable. A company's choice of accounting policies used in its financial statements will impact its ratios, according to Corporate Finance Institute.
No Indication of Cause of Changes
Ratios tell a business owner what happened but they do not tell him why it happened. Business owners must dig deeper into the numbers to determine why ratios are changing from period to period. The Accounts Receivable Turnover ratio is a good example of this, and context is key, says NetSuite.
This ratio shows how quickly accounts receivable are being collected. If the turnover slows, it means a buildup of receivables compared with sales for the period. This buildup could be caused by a number of factors, including employee inexperience, loosened credit policies or growing customer dissatisfaction with the product. A business manager needs to find the root of the problem before it can be solved.
Ratios Based on Book Value
This is one of the largest problems with relying on financial ratios. Because the financial statements are prepared based on book value (largely historical cost), they do not reflect current reality in the business. Ratios that are based on these historical numbers may not be telling the whole story about the health and direction of the company.
This is especially true for asset-based ratios. Assets may be worth more or less than the value carried on the balance sheet. If the company is in financial distress, the liquidation value of those assets will be the most relevant. A price to earnings ratio, meanwhile, may not reflect the high-growth the company is currently experiencing.
No Measurement of Management Quality
Financial ratios, like the financial statements they are based on, do not capture all of the important information that tells stakeholders how the business is doing today and helps them predict where it is going in the future. One of the key determinants of business success is the quality and experience of the management team. This information cannot be derived directly from financial ratios although large ratio swings can give an indication.
FAQs
The first challenge with financial statement analysis is comparison. Once a ratio is calculated, it's important to compare it to a prior period, industry average, or competitor. A second challenge includes ensuring a company is using the same inventory valuation method.
What are some of the problems associated with using financial ratios? ›
Limitations of Ratio Analysis:
- ratio analysis information is historic – it is not current.
- ratio analysis does not take into account external factors such as a worldwide recession.
- ratio analysis does not measure the human element of a firm.
The first challenge with financial statement analysis is comparison. Once a ratio is calculated, it's important to compare it to a prior period, industry average, or competitor. A second challenge includes ensuring a company is using the same inventory valuation method.
Why is it difficult to compare financial ratios? ›
Limited comparability: Financial statements are prepared using different accounting standards and practices, making it difficult to compare companies operating in different jurisdictions or industries.
What problem does using financial ratios eliminate when comparing? ›
The industry problem arises when companies operate in different industries with varying financial characteristics. Financial ratios allow for a comparison that standardizes financial data and removes the industry-specific effects. The size problem occurs when comparing companies of different sizes.
What is the impact of financial ratios? ›
Financial ratios offer entrepreneurs a way to evaluate their company's performance and compare it other similar businesses in their industry. Ratios measure the relationship between two or more components of financial statements. They are used most effectively when results over several periods are compared.
What are the problems that using a financial ratio can present to an investor? ›
Some of the most important limitations of ratio analysis include: Historical Information: Information used in the analysis is based on real past results that are released by the company. Therefore, ratio analysis metrics do not necessarily represent future company performance.
What are the 5 limitations of financial statement analysis? ›
5 Limitations of Financial Analysis
- The financial analysis does not contemplate cost price level changes.
- The financial analysis might be ambiguous without the prior knowledge of the changes in accounting procedure followed by an enterprise.
- Financial analysis is a study of reports of the enterprise.
Issuing reports on financial statements includes the examination of financial statements that are intended to present financial position (balance sheet and statement of retained earnings), results of operations (income statement), and statement of cash flows in conformity with generally accepted accounting principles ...
What are the risks of financial statements? ›
Financial statement-level risks are not risks limited to one account balance, but rather, risks that are pervasive to the financials. For example, one financial statement-level risk would be a lack of expertise in the client's accounting department, which would affect numerous accounts and assertions.
Disadvantages of Ratio Analysis are as follows:
Financial accounting data is influenced by views and hypotheses. Accounting criteria provide different accounting methods, which reduces comparability and thus ratio analysis is less helpful in such circ*mstances.
What are the advantages and disadvantages of financial ratios? ›
Although ratio analysis can be valuable in assessing a firm's financial health, there are some limitations of ratio analysis. For instance, ratio analysis relies on past financial data and may not feel the impact of future changes in the market or a firm's operations.
Why is it difficult to compare the financial statements? ›
The limitations of financial statements include inaccuracies due to intentional manipulation of figures; cross-time or cross-company comparison difficulties if statements are prepared with different accounting methods; and an incomplete record of a firm's economic prospects, some argue, due to a sole focus on financial ...
What are some potential problems of financial ratio analysis? ›
Problems and limitations of financial ratios include the following: Ratios are calculated using the past or what is commonly known as historical data. Historical data are not good predictors of what will happen in the future. Therefore, financial ratios should not be used to predict the future.
Why are financial ratios misleading? ›
Companies may be using different methods in accounting, which would render it difficult for the comparison of the financial ratios. The different accounting methods, assumptions made and estimates that are applied by the companies influence the information of accounting used to compute the ratios.
What is something to watch out for when using financial ratios? ›
One of the most important things to be mindful of is that different sources calculate them differently. This can lead to confusion when comparing ratios from various sources, which can lead to incorrect conclusions. Another thing to keep in mind is that the time it takes to calculate financial ratios can be quite long.
What are the problems with the current ratio? ›
The current ratio helps investors understand more about a company's ability to cover its short-term debt with its current assets and make apples-to-apples comparisons with its competitors and peers. One weakness of the current ratio is its difficulty of comparing the measure across industry groups.
What is the problem with cash ratio? ›
If you have a low cash ratio, you may have trouble paying your short-term obligations, including your credit card bills, payroll, utilities, taxes, and other expenses. You'll likely have to take on debt or sell off some of your business assets to avoid getting into trouble.
How do financial ratios affect each other? ›
Financial ratios express one financial quantity concerning another and they can be used to evaluate the performance of a company over time. By reducing the effect of company size, ratios can also enhance a comparison being made between companies.
