Limitations of Financial Ratio Analysis

I am a big fan of ratio analysis for small business owners. I don’t have to inspire large company CFOs and Controllers to perform ratio analysis, because it is their daily bread, but I find that many small business owners have not yet gained an appreciation of what financial ratios can do for them.

But as much as ratio analysis can help you, it can also mislead, so I thought it would be good to delve into the limitations of financial ratio analysis today.

Ratio analysis can be only as good as the underlying data
Ratios are absolutely wonderful. They boil down a complex set of numbers and relationships to a simple, 1 or 2 digit number which tells you volumes! But beware… What if those complex, underlying data are not accurate? Many important decisions are made because a ratio has changed by 1 or 2 percentage points. Given that, your accountant better make really sure that the calculations can be relied upon.

In the small business environment things like reconciled trial balance (yes, not only the bank accounts!) and monthly, reviewed financial statements cannot be taken for granted. Many small businesses do not have adequate accounting systems in place nor do they all have competent accounting personnel making sure the monthly financial results are not only available, but actually accurate.

Calculating any ratios based on questionable data and an unreconciled set of books can be very dangerous. So, before any analysis is even attempted, the accounting records must be brought up to par.

Ratio comparisons can be meaningful only, if data is truly comparable
It’s a challenge to achieve comparability among different firms, even in the same industry. Different depreciation methods, different inventory valuation methods used, different policy regarding capitalization of certain expenditures make it very hard to arrive at financial statements which can be compared meaningfully.

But even comparisons of different periods within the same company can get tricky. I have seen many small businesses with a high turnover of the bookkeeping/accounting position and my review of the general ledger revealed often that there was no consistency in the way many transactions were posted by those different people. This would make comparisons less valuable than they could otherwise be. This brings us back to our first point – accounting records need to be not only accurate but also consistent.

Ratio analysis reflects only what is in the financial statements
Obviously, financial ratios will reflect only what is contained in the financial reports of the company. And as valuable as that can be, it does not capture many factors which can have a profound impact on the business and yet cannot be quantified or expressed in accounting terms.

I remember acting as a part-time controller for an insurance firm which has just been purchased by an international player. The President was given a certain ratio as a target for his accounting department salary costs. Based on this ratio, he couldn’t add a single person to his accounting staff. On the contrary, to meet the target, he would have to let some people go first.

But that didn’t take into consideration the particular situation this company was in. Due to historical reasons, the staff had very low qualifications, systems were old and the only way out was to bring a strong full-time controller or CFO to reorganize the department. The target ratio wouldn’t allow for that. But it was the best thing to do in those circumstances. Intelligent leadership will recognize such limitations of ratios and make the right business decisions anyway.

Other factors not contained in the financial statements can be technological developments, competitor’s actions, government actions, etc. All elements with potential impact on the business need to be evaluated when making important decisions, not only financial ratios.

Still, financial ratio analysis is a key component of those decisions and I would venture to say that a company which doesn’t avail itself of this information is at a disadvantage.