Financial Ratios - Uses and Limitations of Financial Ratios

Benchmarking Financial Ratios
Financial ratios are not very useful on a stand-alone 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 capital-intensive business and the other is not. As a result, it is better to use a cross-sectional 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 time-series 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 industry-average 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 back-to-school 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
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