Ratio analysis is a useful tool, especially for an outsider such as a credit analyst, lender, or stock analyst, who needs to create a picture of the financial results and position of a business just from its financial statements. Ratio analysis can be used to compare information taken from different parts of the financial statements to gain a general understanding of the results, financial position, and cash flows of a business.
However, there are a number of limitations of ratio analysis that you should be aware of. They are:
- Historical. All of the information used in ratio analysis is derived from actual historical results. This does not mean that the same results will carry forward into the future. However, you can use ratio analysis on pro forma information and compare it to historical results for consistency.
- Historical versus current cost. The information on the income statement is stated in current costs (or close to it), whereas some elements of the balance sheet may be stated at historical cost (which could vary substantially from current costs). This disparity can result in unusual ratio results.
- Aggregation. The information in a financial statement line item that you are using for a ratio analysis may have been aggregated differently in the past, so that running the ratio analysis on a trend line does not compare the same information through the entire trend period.
- Operational changes. A company may change its underlying operational structure to such an extent that a ratio calculated several years ago and compared to the same ratio today would yield a misleading conclusion. For example, if you implemented a constraint analysis system, this might lead to a reduced investment in fixed assets, whereas a ratio analysis might conclude that the company is letting its fixed asset base become too old.
- Accounting policies. Different companies may have different policies for recording the same accounting transaction. This means that comparing the ratio results of different companies may be like comparing apples and oranges. For example, one company might use accelerated depreciation while another company uses straight-line depreciation, or one company records a sale at gross while the other company does so at net.
- Business conditions. You need to place ratio analysis in the context of the general business environment. For example, 60 days of sales outstanding might be considered poor in a period of rapidly growing sales, but might be excellent during an economic contraction when customers are in severe financial condition and unable to pay their bills.
- Interpretation. It can be quite difficult to ascertain the reason for the results of a ratio. For example, a current ratio of 2:1 might appear to be excellent, until you realize that the company just sold a large amount of its stock to bolster its cash position. A more detailed analysis might reveal that the current ratio will only temporarily be at that level, and will probably decline in the near future.
- Company strategy. It can be dangerous to conduct a ratio analysis comparison between two firms that are pursuing different strategies. For example, one company may be following a low-cost strategy, and so is willing to accept a lower gross margin in exchange for more market share. Conversely, a company in the same industry is focusing on a high customer service strategy where its prices are higher and gross margins are higher, but it will never attain the revenue levels of the first company.
- Point in time. Some ratios extract information from the balance sheet. Be aware that the information on the balance sheet is only as of the last day of the reporting period. If there was an unusual spike or decline in the account balance on the last day of the reporting period, this can impact the outcome of the ratio analysis.
In short, ratio analysis has a variety of limitations. However, as long as you are aware of these problems and use alternative and supplemental methods to collect and interpret information, ratio analysis is still useful.