Benefits and Limitations
Benefits
Financial ratios are designed to provide users of information useful metrics to evaluate business activity and health. The results provide a quick and consistent methodology for digging into somewhat complex data and providing helpful insights to facilitate decisions. Projections (educated financial guesses about the future) may also be made based upon historical results and the corresponding ratio. For example, a stakeholder could use the current gross profit margin to project gross profit in the future based upon revenue estimates.
Different stakeholders can benefit from different benefits of ratio analysis. The concepts apply to both internal or intra-company analysis as well as inter-company or peer analysis. Comparing a company’s financial ratios to a peer group is a standard analytical practice that helps give a basis for understanding company-specific ratios. By using a relative comparison to a group of companies operating in similar business lines, an analyst can form conclusions to help decision making. Comparisons are useful when in the same peer group in terms of the products or services offered, size, and structure. A big publically traded software company will be best compared against another big publically traded software company, and so on.
Limitations
Ratios are based on historical information and history is never guaranteed to repeat itself. Historical data can sometimes also include unusual or nonrecurring activities that may not be present going forward. Ratios without context generally have limited value to stakeholders. A video cassette rental company, for example could have strong financial ratios, but be put out of business almost overnight with the release of DVDs and internet streaming. Financial ratios by themselves may not indicate such an abrupt change and therefore must be interpreted along with other circumstances.
Ratios should be combined with other outside data points. Using gross profit margin to predict future cost of goods sold based on revenue, for example, is logical but dangerous if other circumstances are not considered. The ratio itself will not tell the analyst that current prices may have doubled due to supply chain issues or political problems, for example. There have been many companies with strong financial ratios that subsequently failed due to internal and external circumstances.
Ratios provide insights into business metrics, but typically require further analysis to be valuable. A competent financial analyst understands that ratios often create more questions than answers and will increase the scope of research and analysis where appropriate. Financial analysis starts are the numbers, but takes into account other factors outside the balance sheet and income statement. The notes to the financial statements for example can be a very important area of analytical information that provide clues to the accounting methodology, lawsuits, plans, and other required disclosures. Micro and macro political and economic trends will also factor into analysis, such as new law or interest rate changes.