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.
