Limitations of Ratio Analysis

What is Ratio Analysis?

The ratio analysis is a standard method for assessing various elements such as liquidity, solvency, profitability, operational efficiency, interest payability, and the proportion of equity to debt(& more).

Ratio analysis is utilized in the field of financial analysis. And we can say it's a part of financial analysis.

Its purpose is to extract data from financial statements and to create graphical representations of the data. It emphasizes ratios that reflect a company's profitability, efficiency, and other critical information, such as the leverage it finances its operations.

The ratios can be used for horizontal or vertical analysis, depending on the context. However, financial analysts need to be aware of the many restrictions of this kind of analysis, even though it is one of the most common types.

The comparison to industry benchmark companies is an essential factor in ratio analysis. In addition, because it provides significant insights from the financial statements, this type of financial analysis can be helpful to both internal management and outsider analysts of the company.

Ratio analysis, like any other financial analysis technique, has several limitations. It is critical to understand these limitations to avoid drawing incorrect conclusions.

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by examining its financial statements, such as the balance sheet and income statement. Fundamental equity analysis is built on it.

• Ratio analysis compares line-item data from a company's financial statements to elicit information about profitability, liquidity, operational efficiency, and solvency.
• It can show how a company has changed over time and compare one company to another in the same industry or sector.
• While ratios provide helpful information about a company, they should be combined with other metrics to give a complete picture of its financial health.

What are the limitations of ratio analysis?

Ratio analysis compares information from financial statements to understand a company's results, financial position, and cash flows. This analysis is useful for outsiders, such as credit analysts, lenders, or stock analysts. 

These individuals must be able to construct a picture of a company's financial results and position based solely on its financial statements. However, you should be aware of some limitations to ratio analysis.

Some of the most significant limitations of ratio analysis are as follows:

1. Historical Basis of Ratios

The information used in ratio analysis is derived entirely from historical data. Therefore, it does not imply that the same outcomes will be repeated in the future. You can, however, use it on pro forma data and compare it to historical results to ensure consistency.

2. Historical vs. Current Costs

The income statement information is current costs (or close to it). In contrast, some balance sheet elements may be stated at historical costs (which could vary substantially from current costs). This discrepancy can lead to unusual ratio results. 

Because items from the profit and loss statements are based on actual costs, and those from the balance sheet are based on historical data, which can occasionally be deceptive. 

As a result, we are comparing parts as a combination of both might occasionally be misleading and result in unexpected outcomes.

3. Inflationary effects

Because financial statements are released regularly, there are time gaps between each release. Therefore, the figures may differ if the inflation rate changes in any periods under consideration. 

For example, if the inflation rate in one year were 100%, sales would appear to have doubled over the previous year, even if sales had not changed. As a result, numbers from different periods are incomparable until they are adjusted for inflation.

4. Accounting policy changes

If the company's accounting policies and procedures have changed, this may significantly impact financial reporting. 

The key financial metrics used in ratio analysis are changed in this case. As a result, the financial results recorded after the change are not comparable to those recorded before. 

For example, one company may use accelerated depreciation while another uses straight-line depreciation, or one company may record a sale at gross while another does so at the net.

5. Changes in operational structure

A company's operational structure can range from its supply chain strategy to its selling product. 

When significant operational changes occur, comparing financial metrics before and after may lead to inaccurate conclusions about the company's performance and prospects.

A company's underlying operational structure may change to the point where a ratio calculated several years ago and compared to today yields an incorrect conclusion. 

For example, suppose you implemented a constraint analysis system. In that case, you might reduce your investment in fixed assets, whereas a ratio analysis might conclude that the company is allowing its fixed asset base to deteriorate.

Other limitations of Ratio Analysis

In addition to above those significant limitations, ratio analysis is subject to the following additional restrictions:

1. Seasonal effects

An analyst needs to be aware of seasonal factors because those factors can sometimes lead to limitations in ratio analysis. For example, if seasonality effects cannot be factored into the analysis, the results of the analysis could be misinterpreted if that factor needs to be taken into account.

2. Financial statement manipulation

Ratio analysis is based on information reported by the company in its financial statements. As a result, the company's management may manipulate this data to report a better result than its actual performance. 

As a result, it may not accurately reflect the true nature of the business because information misrepresentation needs to be detected by simple analysis. 

3. Aggregation Issues

Because the information in a financial statement line item used for a ratio analysis may have been aggregated differently in the past, running it on a trend line only compares the same information over the entire trend period.

4. Business Situations

It would help if you contextualized ratio analysis within the overall business environment. 

For example, 60 days of sales outstanding for receivables may be considered poor during rapidly increasing sales but excellent during an economic contraction when customers are in dire financial straits and unable to pay their bills.

5. Interpretation

It can take time to determine the cause of a ratio's results. A current ratio of 2:1, for example, may appear excellent until you realize that the company recently sold a large amount of its stock to bolster its cash position. 

6. Business Strategy

A ratio analysis comparison between two firms with opposing strategies can be risky. For example, one company may pursue a low-cost strategy and thus be willing to accept a lower gross margin in exchange for a more significant market share. 

In contrast, a company in the same industry focuses on a high customer service strategy, with higher prices and gross margins. Still, it will only reach the first company's revenue levels.

7. Point in Time

Some ratios derive data from the balance sheet. Please keep in mind that the information on the balance sheet is only current as of the last day of the reporting period. 

If the account balance experiences an unusual spike or decline on the last day of the reporting period, the ratio analysis results may be affected.

In short, ratio analysis has some limitations that limit its utility. However, it is still valid as long as you know these issues and uses alternative and supplemental methods to collect and interpret data.

Ratio analysis vs. Trend Analysis

The purpose of the methodology known as trend analysis, which is a component of technical analysis, is to forecast future movements in stock prices by examining previously gathered trend data. 

Trend analysis uses historical data to forecast the long-term direction of market sentiment. This data includes things like price movements and trade volume.

Financial analysis frequently examines past data and contrasts it with present data. This procedure, known as trend analysis, aids a business in identifying its strengths and weaknesses. 

Since ratios are one method for performing financial reviews or profitability evaluations, there is a connection between ratio and trend analysis. Ratios can also be used for benchmark analysis, in which a company contrasts its financial information with other companies. 

Typically, ratio and trend analysis occur at month-end, year-end, or whenever a company believes a review is required to evaluate financial information.

Financial statements are the same inputs used in both ratio and trend analysis. In addition, these statements are the accounting office's final product for a specific time frame. 

The dollar difference between each line on a financial statement is often measured for trend analysis. However, the percentage difference between the items could also be given in a separate column which offers a brief overview of financial progress in specific company categories.

It takes a little longer to calculate ratios. Therefore, accountants need to utilize several mathematical formulas to generate the indicators or percentages indicative of ratios. However, the ratios can establish a link between ratio and trend analysis. 

A financial comparison trend can be created, for instance, by an accountant keeping track of each ratio calculated over time.

The use of ratio and trend analysis in-stock selection is another relationship. For example, on stock price charts, many investors seek patterns because they can tell when to buy a stock based on these trends. 

The company issuing the stock must then be examined as part of the fundamental examination. This need can be satisfied by ratios, which can also be used to match a financially sound company's stock price trajectory. 

One technique to finish this research is calculating a modest set of statistics to assess the company's:

• Profitability
• Asset turnover
• Financial leverage

Ratios also allow organizations to contrast their performance with rivals operating differently. A small company, for instance, cannot match the sales or other operational capacities of a much larger company. 

However, ratios eliminate these variations and show how well the tiny company performs compared to the significant rival. 

The small firm can also use this to create a ratio and trend analysis report which advises how the small firm can grow to resemble a larger enterprise.

To evaluate the profitability and performance of enterprises, trend analysis and ratio analysis are used. These assessments can give firms insight into their business performance during a specific period, regardless of the size and scope of their businesses. 

Trend and ratio analyses are related since ratio analysis is frequently used to calculate trends.

The importance of Ratio Analysis

Ratio analysis is a method that investors and analysts use to evaluate a company's financial health. This method involves carefully examining both historical and current financial statements. 

Data that can compare can be used to show how well a company has done over time and can also be used to make predictions about how well it will do in the future.

This information can be used to evaluate a company's standing in its industry relative to its competitors and benchmark the company's financial performance in comparison to the norms of its sector.

A company's financial statements contain all the information required to calculate the ratios, making it simple for investors to implement this method.

The ratios that companies use as benchmarks are beneficial. They evaluate the stocks that belong to a particular industry. In addition, they contrast a company's current performance with its previous results.

Because management can occasionally alter its strategy to improve stock and company ratios, it is typically vital for management to have a solid understanding of the factors that influence ratios. 

Instead of being used singularly, ratios are typically applied in conjunction with many other ratios.

Suppose you have a solid understanding of the ratios in each of the four previously mentioned categories. In that case, you will obtain a comprehensive understanding of the organization from various perspectives and be better able to recognize potential warning signs.

Researched and Authored By Ruxue Bai | LinkedIn

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