Advantages and Limitations of Ratio Analysis
Financial ratio analysis is a useful tool for users of financial statements because it allows them to compare a company's financial performance and financial position across time and with its competitors.
The strength of financial ratio analysis lies is its simplicity and comparability which helps us in the following ways:
- Financial ratio analysis simplifies a company's financial statements and allows us to express critical profitability and financial position information in just a few numbers. For example, net profit margin encapsulates the net effect of a company's revenues and all expenses. It enables us to reach a conclusion about a company's profitability without going through the company's income statement.
- It helps in comparing companies of different size with each other. For example, if Company A has a revenue twice the size of Company B, their net profit is not directly comparable unless we standardize it by dividing it by their net revenue. Financial ratio analysis helps with such standardization.
- It helps in trend analysis which involves comparing a single company over a period.
- It highlights important information in simple form quickly. A user can judge a company by just looking at few numbers instead of reading the whole financial statements.
Despite its usefulness, financial ratio analysis suffers from some drawbacks, including:
- Financial ratio analysis is useful only when comparison is made between two companies from the same industries. Many companies have multiple lines of business and their financial statements provide a composite view of the company. Comparing a company with industry average is not very useful because the average also includes companies who have been performing poorly.
- Different companies follow different financial reporting frameworks, which allow different accounting policies for identical transactions. In such a situation, it is important to adjust one company's financial statements. For example, if one company prepares its financial statements under IFRS and another follows US GAAP, we must convert the IFRS financial statements to US GAAP or vice versa.
- Management's ability to change assumptions potentially allows them to manage their ratios by changing accounting assumptions from period to period which could impairs the comparability of financial ratios.
- Ratio analysis explains relationships between past information while users are more concerned about current and future information.
- The calculation methodology of different ratios is not standardized. For example, some analysts calculate return on assets by dividing net income by average assets while others base on operating income and use closing total assets balance in the denominator.