Financial Ratios  Uses and Limitations of Financial Ratios
Benchmarking Financial Ratios
Financial ratios are not very useful on a standalone basis; they must be benchmarked against something. Analysts compare ratios against the following:
1.The Industry norm  This is the most common type of comparison. Analysts will typically look for companies within the same industry and develop an industry average, which they will compare to the company they are evaluating. Ratios per industry are also provided by Bloomberg and the S&P. These are good sources of general industry information. Unfortunately, there are several companies included in an index that can distort certain ratios. If we look at the food and beverage ratio index, it will include companies that make prepared foods and some that are distributors. The ratios in this case would be distorted because one is a capitalintensive business and the other is not. As a result, it is better to use a crosssectional analysis, i.e. individually select the companies that best fit the company being analyzed.
2.Aggregate economy  It is sometimes important to analyze a company's ratio over a full economic cycle. This will help the analyst understand and estimate a company's performance in changing economic conditions, such as a recession.
3.The company's past performance  This is a very common analysis. It is similar to a timeseries analysis, which looks mostly for trends in ratios.
Limitations of Financial Ratios
There are some important limitations of financial ratios that analysts should be conscious of:
 Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industryaverage ratios.
 Inflation may have badly distorted a company's balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment.
 Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer's inventory may be high in the summer in preparation for the backtoschool season. As a result, the company's accounts payable will be high and its ROA low.
 Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc.).
 It is difficult to generalize about whether a ratio is good or not. A high cash ratio in a historically classified growth company may be interpreted as a good sign, but could also be seen as a sign that the company is no longer a growth company and should command lower valuations.
 A company may have some good and some bad ratios, making it difficult to tell if it's a good or weak company.
In general, ratio analysis conducted in a mechanical, unthinking manner is dangerous. On the other hand, if used intelligently, ratio analysis can provide insightful information.
Basic Earnings Per Share
Investing Basics
Analyze Investments Quickly With Ratios
Make informed decisions about your investments with these easy equations. 
Investing
Ratio Analysis
Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ... 
Investing Basics
Do Your Investments Have ShortTerm Health?
If a company is strong enough to survive tough times, it is more likely to provide longterm value. 
Trading Strategies
Financial Ratios to Spot Companies Headed for Bankruptcy
Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy. 
Forex Education
6. Analyze With Ratios
Learning to read the balance sheet can provide great insight into the financial strength of a company. 
Technical Indicators
Key Financial Ratios to Analyze Tech Companies
Understand the technology industry and the companies that operate in it. Learn about the key financial ratios used to analyze tech companies. 
Fundamental Analysis
Ratio Analysis: Using Financial Ratios
There is a lot to be said for valuing a company, it is no easy task. If you have yet to discover this goldmine, the satisfaction one gets from tearing apart a companies financial statements and ... 
Fundamental Analysis
Efficiency Ratio
There are many types of efficiency ratios, but all measure how well a company utilizes its resources to make a profit. Business managers use these ratios to determine how well they are operating ... 
Fundamental Analysis
Dynamic Current Ratio: What It Is And How To Use It
Learn why this ratio may be a good alternative to the current, cash and quick ratios. 
Investing Basics
Why do Debt to Equity Ratios Vary From Industry to Industry?
Obtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries.

Ratio Analysis
A ratio analysis is a quantitative analysis of information contained ... 
Current Ratio
The current ratio is a liquidity ratio measuring a company's ... 
Accounting Ratio
A way of expressing the relationship between one accounting result ... 
Key Ratio
A mathematical ratio that illustrates and summarizes the current ... 
Activity Ratios
Accounting ratios that measure a firm's ability to convert different ... 
Combined Ratio
A measure of profitability used by an insurance company to indicate ...

How do stock dividends affect the retained earnings account?
Understand the difference between financial ratio analysis and accounting ratio analysis. Learn why ratio analysis is important ... Read Answer >> 
What role does ratio analysis play in valuing a company?
Learn about the role of ratio analysis in determining company value, including some of the most common ratios used by modern ... Read Answer >> 
To what extent should you take a company's liquidity ratio into account before investing ...
Find out how important it is for an investor to know a company's liquidity ratio before deciding to invest, and why relying ... Read Answer >> 
Which financial metrics are best for analyzing companies in the chemicals sector?
Learn about some of the key financial metrics that investors and market analysts commonly use to evaluate companies in the ... Read Answer >> 
What types of information does one need to perform a thorough financial analysis?
Understand what types of information an analyst needs to examine for a thorough financial analysis, and learn how to use ... Read Answer >> 
How does ratio analysis make it easier to compare different companies?
Learn what ratio analysis is, how investors can compare companies within the same sector using ratio analysis and how ratios ... Read Answer >>