Ratio Analysis
Tayeba akter
Army IBA, Savar
Ratio Analysis
• Ratio comes from rational (or more properly from the Latin word ratio meaning
'(something) rational; reason’,
• a study of the relationships between different amounts or numbers in a company's
financial records in order to see how successful the company is.
• The mathematical sense of "relation between two similar magnitudes in respect to
quantity,"
What is Ratio Analysis?
Ratio analysis refers to the analysis of various pieces of financial information
in the financial statements of a business. They are mainly used by external
analysts to determine various aspects of a business, such as its profitability,
liquidity, and solvency.
Analysts rely on current and past financial statements to obtain data to
evaluate the financial performance of a company. They use the data to
determine if a company’s financial health is on an upward or downward trend
and to draw comparisons to other competing firms.
• Ratio analysis helps people analyze financial factors like profitability,
liquidity and efficiency.
• Ratio analysis helps financial professionals understand company trends and
perform competitive analysis.
• Common ratio analysis includes liquidity, leverage, market value and
efficiency ratios.
Uses of Ratio Analysis
1. Comparisons
One of the uses of ratio analysis is to compare a company’s financial performance to similar firms in the
industry to understand the company’s position in the market. Obtaining financial ratios, such as
Price/Earnings, from known competitors and comparing it to the company’s ratios can help management
identify market gaps and examine its competitive advantages, strengths, and weaknesses. The
management can then use the information to formulate decisions that aim to improve the company’s
position in the market.
2. Trend line
Companies can also use ratios to see if there is a trend in financial performance. Established companies
collect data from the financial statements over a large number of reporting periods. The trend obtained can
be used to predict the direction of future financial performance, and also identify any expected financial
turbulence that would not be possible to predict using ratios for a single reporting period.
3. Operational efficiency
The management of a company can also use financial ratio analysis to determine the degree of efficiency
in the management of assets and liabilities. Inefficient use of assets such as motor vehicles, land, and
building results in unnecessary expenses that ought to be eliminated. Financial ratios can also help to
determine if the financial resources are over- or under-utilized.
Ratio Analysis – Categories of Financial Ratios
There are numerous financial ratios that are used for ratio analysis, and they are grouped into the following
categories:
1. Liquidity ratios
• Liquidity ratios measure a company’s ability to meet its debt obligations using its current assets. When a company
is experiencing financial difficulties and is unable to pay its debts, it can convert its assets into cash and use the
money to settle any pending debts with more ease.
• Some common liquidity ratios include the quick ratio, the cash ratio, and the current ratio. Liquidity ratios are used
by banks, creditors, and suppliers to determine if a client has the ability to honor their financial obligations as they
come due.
2. Solvency ratios
• Solvency ratios measure a company’s long-term financial viability. These ratios compare the debt levels of a
company to its assets, equity, or annual earnings.
• Important solvency ratios include the debt to capital ratio, debt ratio, interest coverage ratio, and equity multiplier.
Solvency ratios are mainly used by governments, banks, employees, and institutional investors.
3. Profitability Ratios
• Profitability ratios measure a business’ ability to earn profits, relative to their associated expenses. Recording a
higher profitability ratio than in the previous financial reporting period shows that the business is improving
financially. A profitability ratio can also be compared to a similar firm’s ratio to determine how profitable the
business is relative to its competitors.
• Some examples of important profitability ratios include the return on equity ratio, return on assets, profit margin,
gross margin, and return on capital employed.
4. Efficiency ratios
• Efficiency ratios measure how well the business is using its assets and liabilities to generate sales
and earn profits. They calculate the use of inventory, machinery utilization, turnover of liabilities, as
well as the usage of equity. These ratios are important because, when there is an improvement in the
efficiency ratios, the business stands to generate more revenues and profits.
• Some of the important efficiency ratios include the asset turnover ratio, inventory turnover, payables
turnover, working capital turnover, fixed asset turnover, and receivables turnover ratio.
5. Coverage ratios
• Coverage ratios measure a business’ ability to service its debts and other obligations. Analysts can
use the coverage ratios across several reporting periods to draw a trend that predicts the company’s
financial position in the future. A higher coverage ratio means that a business can service its debts
and associated obligations with greater ease.
• Key coverage ratios include the debt coverage ratio, interest coverage, fixed charge coverage, and
EBIDTA coverage.
6. Market prospect ratios
• Market prospect ratios help investors to predict how much they will earn from specific investments.
The earnings can be in the form of higher stock value or future dividends. Investors can use current
earnings and dividends to help determine the probable future stock price and the dividends they
may expect to earn.
• Key market prospect ratios include dividend yield, earnings per share, the price-to-earnings ratio,
and the dividend payout ratio.
Ratio analysis is an accounting method that uses financial
statements, like balance sheets and income statements, to
gain insights into a company's financial health. Ratio analysis
will help determine various aspects of an organization
including profitability, liquidity and market value.
Profitability ratios
Profitability ratios are a type of financial ratio that assesses the ability of a business
to generate earnings compared to its revenue, operating costs, assets or
shareholder equity. You can use these ratios to discover how profitable a company
is. There are a few types of profitability ratios:
• Operating profit margin
• Gross profit margin
• EBITDA margin
• Net profit margin
• Cash flow margin
• Return on equity
• Return on assets
• Return on invested capital
Higher profitability ratios mean a business is performing well. To assess if a
company has higher ratios, you can compare current ratio values to the company's
Why Are Profitability Ratios Significant?
Profitability ratios are significant because they allow stakeholders to see a company's performance with
some precision. This financial analysis information can be of special value in certain circumstances:
• Attracting investors: Investors understandably want to see that a business has the capacity to be
profitable before they make any investments. Profitability ratios provide the data investors need to make
sound investment decisions.
• Assessing seasonal businesses: Businesses whose net sales revenue varies greatly from one
season to the next (such as retailers who make most of their income during the year-end holidays or
recreational equipment companies who rely on summertime sales) can benefit from using profitability
ratios. By comparing historical performance and the company's earnings across the same quarters over
several years, management has a clear measure of profitability that helps them make smart budgeting
and strategic planning decisions.
• Revealing problematic sectors of a company: Financial statements, including balance
sheets and income statements, can only reveal the big picture about a business. Assessments that
include profitability ratios allow analysts to investigate various areas of the business to spot specific
problems, such as a rising cost of goods sold.
• Comparing a company to competitors: If competitors are more established than a small
business, a comparison of revenue may not be revelatory or helpful. However, a comparison of
profitability ratios lets small business owners know how they measure up in terms of efficiency and
profit, which is helpful.
3 Types of Profitability Ratios
The most useful types of profitability ratios can be categorized in three
ways:
1.1. Margin ratios: Margin ratios give insight, from several different
angles, on a company's ability to turn total sales into profits.
2.2. Return ratios: Return ratios, which are calculated using data
from a company's profit and loss statement and balance sheet, provide
information about how well the business generates returns. This ratio
measures how well the company converts assets, equity, and debt into
return on investment.
3.3. Cash flow ratios: Cash flow ratios move beyond the bottom line
to help businesses understand whether they're running a cash surplus
or deficit. They're particularly important because a lack of cash can
cause even a profitable business to fail.
5 Important Margin Ratios
Among the key margin ratios that provide useful data are:
1.1. Gross profit margin ratio: Measures a company's net income
after subtracting the cost of goods sold (COGS).
2.2. Net profit margin ratio: Measures income and earnings after
all expenses and taxes have been deducted.
3.3. Operating profit margin: Measures sales income after
subtracting operating expenses and COGS.
4.4. Pretax margin: Measures company profits after subtracting
operating costs, non-operating expenses, and COGS.
5.5. EBITDA margin: Measures earnings before interest, income tax
and other taxes, depreciation, and amortization (EBITDA); some
companies also measure EBIT (earnings before interest and tax).
3 Common Return Ratios
The most common return ratios are:
1.1. Return on equity (ROE): Shows how well a company uses
investments to generate profits. Calculated as net profits divided by
investors' or shareholders' equity, this equity ratio helps to evaluate the
efficacy of a company's financial management.
2.2. Return on assets (ROA): Shows how well a company uses its
total assets to generate profits and can be increased through
economies of scale. This asset ratio is particularly useful for
companies in sectors that require significant investment in assets, such
as the telecommunications or manufacturing sectors.
3.3. Return on capital employed (ROCE): Indicates how well a
company uses its capital resources, including retained earnings, share
capital, and long-term debt.
2 Cash Flow Ratios
The two most useful cash flow ratios are:
• Cash flow margin ratio: Measures cash movement across a
given period by adding changes in working capital and non-cash
entries back into the company's net profits.
• Net cash flow ratio: Measures whether a company is running a
cash surplus or deficit to determine whether it needs additional
financing.
Liquidity ratios
Liquidity ratios, also known as coverage ratios, work with ratio analysis to
determine whether or not a company can pay off its short-term debt.
These ratios use values from financial statements to compare assets and
income to the amount of debt a business has. The term also refers to a
company's ability to use its assets to pay off its debts.
• Here are a few types of liquidity ratios:
• Quick ratio
• Current ratio
• Cash ratio
• Times interest earned ratio
• Days sales outstanding
A company that is more liquid than it has been in the past or than its
competitors may be in an economic upturn, while one whose debt
increases may not be the best investment.
How to Calculate Liquidity Ratio?
Liquidity is defined as how quickly an asset can be converted into cash – so assets that can be sold and
turned into cash in a short amount of time are considered to be highly liquid (and vice versa for assets with
low liquidity).
• Other than cash itself, common examples of current assets recorded on the balance sheet with the highest
liquidity include:
• Treasury Bills and Treasury Bonds
• Certificate of Deposits (CDs)
• Marketable Securities
• Short-Term Investments
• Money Market Funds
• The current assets listed above are often consolidated within the “Cash and Cash Equivalents” line item.
• Other current assets considered to be highly liquid include:
• Accounts Receivable (A/R)
• Inventory
• However, the actual liquidity of these assets tends to be dependent on the company (and financial
circumstances).
1. Current Ratio Formula
• The current ratio measures a company’s capacity to pay off all its short-term
obligations.
• Current Assets – Cash & Equivalents, Marketable Securities, Accounts
Receivable (A/R), Inventory
• Current Liabilities – Accounts Payable(A/P), Accrued Expenses, Short-Term
Debt
• The current ratio includes all current assets that can be converted into cash
within one year and all current liabilities with maturities within one year.
• Generally, a current ratio around 1.5x to 3.0x is considered “healthy,” with a
current ratio of <1.0x being a sign of impending liquidity problems.
• Current Ratio = Current Assets ÷ Current Liabilities
2. Quick Ratio Formula
• The quick ratio is a more stringent variation of the current ratio, including
only the most liquid assets – or more specifically, assets that can be
converted into cash within 90 days with a high degree of certainty.
• While dependent on the specific industry, the quick ratio should generally
exceed >1.0x.
• Quick Ratio = (Cash & Equivalents + Marketable Securities + Accounts
Receivable) ÷ Current Liabilities
3. Cash Ratio Formula
• Of the ratios listed thus far, the cash ratio is the most conservative
measure of liquidity.
• The cash ratio measures a company’s ability to meet short-term
obligations using only cash and cash equivalents(e.g. marketable
securities).
• If the cash ratio equals 1.0x, the company has exactly enough cash and
cash equivalents to pay off short-term liabilities, so anything higher
would be considered a positive sign (i.e. cash & equivalents are
adequate).
• Cash Ratio = Cash & Cash Equivalents ÷ Current Liabilities
Leverage ratios
Leverage ratios are also called debt ratios or solvency ratios. Like
liquidity ratios, leverage ratios deal with debt but with the goal of
assessing a business's capability to fulfill its long-term debt
obligations instead of the ability to pay off its debt in the short term.
Examples of commonly used leverage ratios include:
• Debt to equity ratio
• Debt to assets ratio
• Interest coverage ratio
Leverage ratios will give you a long-term view of a business's
financial health over time or compared to other enterprises.
The Debt-to-Equity (D/E) Ratio
This is expressed as:
Debt-to-Equity Ratio=Total Liabilities/
Total Shareholders’ Equity
Debt to EBITDA Ratio = Total Debt ÷ EBITDA
Ratio Type Purpose Formula
Debt-to-Assets Ratio •The debt-to-assets ratio compares a company’s •Debt-to-Assets Ratio = Total Debt / Total Assets
total debt to its assets, with a higher value
meaning that the company has purchased the
majority of its assets using debt.
Debt-to-Equity Ratio (D/E) •The debt-to-equity ratio compares a company’s •Debt-to-Equity Ratio (D/E) = Total Debt / Total
debt to the shareholders’ equity, with a high ratio Equity
suggesting the company’s operations have been
financed with more debt.
Debt-to-Total Capitalization •The debt-to-capital ratio compares the total debt •Debt-to-Total Capitalization = Total Debt / (Debt +
to the sum of all capital sources, with the purpose Equity + Minority Interest + Preferred Stock)
of measuring the percentage of the total capital
structure attributable to debt.
Net Debt-to-Total Capitalization •The inherent assumption in the net debt-to-capital •Net Debt-to-Capital = (Total Debt – Cash) / (Debt
ratio is that the cash on the B/S can be used to + Equity + Minority Interest + Preferred Stock –
help pay down existing debt – thus the total debt Cash)
amount is adjusted to account for the available
cash balance.
What is the Difference Between Credit Risk and
Default Risk?
• The default risk is a sub-set of credit risk that refers to the risk that
the borrower might default on (i.e. fail to repay) its debt obligations.
• Excessive reliance on debt financing could lead to a potential default
and eventual bankruptcy in the worst-case scenario.
• Often, a company will raise debt capital when it is well-off financially
and operations appear stable, but downturns in the economy and
unexpected events can quickly turn the company’s trajectory around.
• Sometimes the best course of action could be to potentially hire
a restructuring advisory firm in anticipation of a missed interest
payment (i.e. default on debt) and/or breached debt covenant.
• From a restructuring standpoint, the earlier the company can get in
front of the problem without involving the Bankruptcy Court, the
better off the company is likely going to be.
Leverage Ratios vs. Coverage Ratios: Understanding
Financial Risk
• Leverage ratios set a ceiling on the debt levels of a company, whereas coverage ratios set
a minimum floor that the company’s cash flow cannot fall below.
• Higher Ratio → Typically, higher leverage ratios often indicate that the company has raised
debt capital near its full debt capacity or beyond the amount it could reasonably handle.
• Lower Ratio → Unlike coverage ratios, lower leverage ratios are viewed as a positive sign
in terms of financial health.
• For example, the higher the times interest earned ratio (TIE), the better off the company
is, because a higher ratio means the company can pay off its interest expense multiple
times using the cash flows it generates.
• In contrast, higher leverage relative to comparable peers could be concerning, especially if
the ratio has been trending upward in recent periods, as the two potential drivers are:
[Link] proxy for operating cash flow, EBITDA, has been declining.
[Link] amount of total debt outstanding has remained constant (or potentially increased).
• From the perspective of lenders, a higher ratio of debt relative to its cash flow, assets, or
equity indicates the company chose to take on a large amount of debt, thereby increasing
the likelihood that it could fail to service a debt payment on time due to lack of liquidity or
cash flows.
What Is a Coverage Ratio?
A coverage ratio, broadly, is a metric intended to measure a company's ability to service its
debt and meet its financial obligations, such as interest payments or dividends. The higher
the coverage ratio, the easier it should be to make interest payments on its debt or pay
dividends. The trend of coverage ratios over time is also studied by analysts and investors to
ascertain the change in a company's financial position.
KEY TAKEAWAYS
• A coverage ratio, broadly, is a measure of a company's ability to service its debt and meet
its financial obligations.
• The higher the coverage ratio, the easier it should be to make interest payments on its debt
or pay dividends.
• Coverage ratios come in several forms and can be used to help identify companies in a
potentially troubled financial situation.
• Common coverage ratios include the interest coverage ratio, debt service coverage ratio,
and asset coverage ratio.
Interest Coverage Ratio = EBIT / Interest Expense
where:
EBIT = Earnings before interest and taxes
An interest coverage ratio of two or higher is generally considered
satisfactory.
Asset Coverage Ratio = Total Assets - Short-term
Liabilities / Total Debt
where:
Total Assets = Tangibles, such as land, buildings, machinery, and inventory
As a rule of thumb, utilities should have an asset coverage ratio of at least
1.5, and industrial companies should have an asset coverage ratio of at least
2.
Market value ratios
Market value ratios determine the current share price of a company's stock.
Investors use these values to determine if a business's stock is overvalued or
undervalued. Like the other types of ratio analysis, there are a few subtypes of
market value ratios, including:
• Book value per share
• Dividend yield
• Earnings per share
• Market value per share
• Price/earnings ratio
You will commonly see market value ratios on stock charts. Because they are
well known, you can find average values for many industries to compare against
single companies to determine their relation to the marketplace.
Market value ratios, measures used to assess a firm’s overall
market price. Common ratios used include earnings per share, the
price/earnings ratio, and book value per share.
• Earnings per Share (EPS)
• Earnings per share (EPS) measures the portion of a corporation’s profit allocated to
each outstanding share of common stock. An increasing earnings per share can
drive up a stock price. Conversely, falling earnings per share can lower a stock’s
market price. Earnings per share is also a component in calculating the price-to-
earnings ratio (the market price of the stock divided by its earnings per share),
which many investors find to be a key indicator of the value of a company’s stock.
• It’s key to note, however, that EPS, like any ratio, should be used with caution and in
tandem with other ratios and contextual data. Many financial professionals choose
not to rely on income statement data and, similarly, EPS because they feel the cash
flow statement provides more reliable and insightful information.
Calculating Earnings per Share
Earnings per share is the profit a company earns for each of its outstanding common shares.
Both the balance sheet and income statement are needed to calculate earnings per share. The
balance sheet provides details on the preferred dividend rate, the total par value of the
preferred stock, and the number of common shares outstanding. The income statement
indicates the net income for the period. The formula to calculate basic earnings per share is
Earnings per Share=Net Income − Preferred Dividends / Weighted Average Common Shares
Outstanding
By removing the preferred dividends from net income, the numerator represents the profit
available to common shareholders. Because preferred dividends represent the amount of net
income to be distributed to preferred shareholders, this portion of the income is obviously not
available for common shareholders. While a number of variations of measuring a company’s
profit, such as NOPAT (net operating profit after taxes) and EBITDA (earnings before interest,
taxes, depreciation, and amortization), are used in the financial world, GAAP requires companies
to calculate earnings per share based on a corporation’s net income, as this amount appears
directly on a company’s income statement, which for public companies must be audited.
Price/Earnings (P/E) Ratio
The price/earnings (P/E) ratio measures the current market share price of a company’s stock
relative to its earnings per share (EPS). The ratio is helpful in comparing performance and
stock price of a company to other companies. It’s also helpful in evaluating how much
investors are willing to pay for earnings performance. Investors, in particular, use this ratio
and rely on two key characteristics: past performance (trailing) and future estimates
(forward). Trailing data can be calculated but is also easily found online, as it’s a common
measure reported on financial sites. Investors will often look for P/E TTM, which is the
price/earnings ratio for the trailing 12 months (last year worth of earnings data). This helps
investors assess one day’s stock price relative to the earnings per share over the past 12
months. P/E ratio is widely used by investors to determine if a stock is over- or
undervalued. It also helps them compare one firm to that of the industry average or index,
such as the S&P 500.
Price/Earnings Ratio=Market Value per Share/Earnings per Share
Book Value per Share
Book value per share is often used hand in hand with market value per share. Investors
compare the two in order to see if the stock is possibly over- or undervalued. Book value
is derived from accounting practices and shows the value of the firm on paper. Market
value, on the other hand, is determined by supply and demand, based on what investors
are willing to pay for the stock. If the market value per share is higher than the book
value, the stock is considered overvalued. If the market value is lower than the book
value, it’s considered undervalued.
In theory, book value per share represents the total value common shareholders would
receive if the firm were liquidated. It is total equity less preferred equity, spread across
the total shares outstanding. The formula to calculate book value per share is
Book Value per Share=Total Equity – Preferred Equity/Total Shares Outstanding
Efficiency ratios
Efficiency ratios assess how well an enterprise uses its resources
internally. Some things an efficiency ratio can calculate for you are:
• Receivables turnover
• Repayment of liabilities
• Quality of equity
• Usage of equity
• Inventory turnover
• Equipment turnover
You can compare these ratios to other companies in the same
industry to determine how well a business is managed. When a
business increases in efficiency, that also increases its profitability.
Efficiency ratios, also known as
activity ratios, are used by
analysts to measure the
performance of a company's
short-term or current
performance. All these ratios
use numbers in a company's
current assets or current
liabilities, quantifying the
operations of the business.
Formula
• Net Credit Purchases = Cost of Goods Sold (COGS) + Ending Inventory balance –
Starting Inventory balance for a specified period. However, this is the formula for
purchases in general. Net credit purchases are only the purchases made on credit.
Alternatively, since the number for net credit purchases is difficult to find, analysts
often substitute COGS as the numerator instead.
• Average Accounts Payable is the sum of starting and ending accounts payable
balances over a time period (e.g., monthly or quarterly), divided by 2. Both balances
can be found on the company’s balance sheet.
• Net Sales = Sales minus Sales returns, Sales discounts, and Sales allowances
• Average Total Assets = (Total assets at the end of the period + Total assets at the
beginning of the period) / 2.
The main points of importance are as follows:
• 1. Test of solvency. Ratios can illuminate the solvency of a firm. For example, when the
ratio of current assets to current liabilities is increasing, this indicates sufficient working capital. Thus,
creditors can be paid easily.
• 2. Helpful in decision-making. The main aim of financial statements is to inform users about the financial
position of the company, as well as to serve as a decision-making aid for managerial personnel.
• 3. Helpful in financial forecasting and planning. Ratios are critical in financial planning and
forecasting. For example, if a firm's current ratio is 5:1, this means that capital is blocked up. As the ideal
ratio is 2:1, we have 5:1, meaning that $3 is unnecessarily blocked.
• 4. Useful in discovering profitability. Ratios are also useful when comparing the profitability of different
companies. Present and past ratios can be compared, for example, to discover trends in the historical and
future performance of companies.
• 5. Liquidity position. With the use of ratio analysis, meaningful conclusions can be obtained about the
sound liquidity position of the firm. A firm's liquidity position is sound if it can pay its debts when these are
due for payments.
• 6. Useful for operating efficiency. From a management perspective, ratios enable managers to measure
the efficiency of assets. When sales and their contribution to net profit increase every year, this is a test of
higher efficiency.
• 7. Business trends. Ratio analysis can expose trends that managers may use to take corrective actions.
• 8. Helpful in cost control. Ratios are useful to measure performance and facilitate cost control.
• 9. Helpful in analyzing corporate financial health. Ratio analysis can provide information about
liquidity, solvency, profitability, and capital gearing. Thus, they are valuable for learning about financial
health.
• Analysis Of Financial Position
• Ratio analysis is an efficient tool for analyzing the financial position of an
organization. It through evaluating the financial statements depicts the true
financial condition of business to owners, creditors, bankers, and investors.
Forecasting And Planning
• Ratio analysis helps in identifying the trends of various items like cost, profit,
and sales. It calculates the relevant accounting ratios with the help of past
financial data which helps in forecasting and planning business activities.
• Simplifies Accounting Information
• Ratio analysis through the computing of various accounting ratios simplifies the
whole information contained in the financial statements of the company. It
makes understanding of whole financial data quite easy by managers and
investors.
Limitations of Ratio Analysis
• Although ratios are useful tools, they should be used with the utmost care. This is because they can suffer from
drawbacks and limitations, including:
• 1. Need for technical knowledge. Ratios are quantitative and not qualitative indicators. Thus, to use them, one
needs some knowledge of quantitative analysis.
• 2. Lack of reliable data. When figures are incorrect (e.g., value of closing stock is overstated), ratios will give
misleading results.
• 3. Different basis. Different methods are available for the valuation of closing stock: LIFO and FIFO. In both, profit
will differ. Similarly, profit has different meanings.
• For example, some companies may take profit before tax and interest, while others may take profit after tax and
interest. Similarly, different methods of depreciation will show different amounts of profit.
• 4. Different accounting policies. Different firms follow different policies with regard to depreciation (e.g.,
fixed installments or diminishing balance method, or stock valuation). Therefore, unless adjustments for profit
are made, profit will not be comparable.
• 5. Effect of price level change. When ratios are calculated, no thought is given to inflationary measures that are
responsible for changes in price. Thus, the utility of ratio analysis becomes questionable in these cases.
• 6. Bias. Ratios are only tools. They depend on the user for practical shape. For example, profit has different meanings,
including EBIT (earnings before interest and taxes). Thus, personal opinion differs from business to business.
• 7. Lack of comparison. Different firms adopt different procedures, records, objectives, and policies. Due to this,
comparisons become complex.
• 8. Evaluation. There are different tools for ratio analysis. The question of which tool to use in a particular situation
depends upon the skill, training, knowledge, and expertise of the analyst.
What are the limitations of ratio analysis?
• Some of the most important limitations of ratio analysis include:
• Historical Information: Information used in the analysis is based on real past results that are released by the
company. Therefore, ratio analysis metrics do not necessarily represent future company performance.
• Inflationary effects: Financial statements are released periodically and, therefore, there are time differences
between each release. If inflation has occurred in between periods, then real prices are not reflected in the financial
statements. Thus, the numbers across different periods are not comparable until they are adjusted for inflation.
• Changes in accounting policies: If the company has changed its accounting policies and procedures, this may
significantly affect financial reporting. In this case, the key financial metrics utilized in ratio analysis are altered,
and the financial results recorded after the change are not comparable to the results recorded before the change. It
is up to the analyst to be up to date with changes to accounting policies. Changes made are generally found in the
notes to the financial statements section.
• Operational changes: A company may significantly change its operational structure, anything from their
supply chain strategy to the product that they are selling. When significant operational changes occur, the
comparison of financial metrics before and after the operational change may lead to misleading conclusions about
the company’s performance and future prospects.
• Seasonal effects: An analyst should be aware of seasonal factors that could potentially result in limitations of
ratio analysis. The inability to adjust the ratio analysis to the seasonality effects may lead to false interpretations of
the results from the analysis.
• Manipulation of financial statements: Ratio analysis is based on information that is reported by the company in
its financial statements. This information may be manipulated by the company’s management to report a better
result than its actual performance. Hence, ratio analysis may not accurately reflect the true nature of the business,
as the misrepresentation of information is not detected by simple analysis. It is important that an analyst is aware
of these possible manipulations and always complete extensive due diligence before reaching any conclusions.
