Limitations of financial ratio analysis

I’m a big fan of ratio analysis for small business owners. I don’t have to inspire CFOs and controllers of large companies to do ratio analysis, because it’s their bread and butter, but I find that many small business owners have yet to realize what financial ratios can do. do for them.

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

Ratio analysis can only be as good as the underlying data

The proportions are absolutely wonderful. They reduce a complex set of numbers and relationships to a simple 1 or 2 digit number that tells you volumes! But be careful … what if that complex and underlying data is not accurate? Many important decisions are made because a proportion has changed by 1 or 2 percentage points. Given that, it’s best if your accountant really makes sure the calculations can be trusted.

In the small business environment, things like reconciled trial balance (yes, not just bank accounts) and monthly reviewed financial statements cannot be taken for granted. Many small businesses do not have proper accounting systems, nor do they all have competent accounting staff who make sure that monthly financial results are not only available, but are actually accurate.

Calculating any ratio based on questionable data and an unreconciled set of books can be very dangerous. Therefore, before attempting any analysis, the accounting records must be updated by.

Ratio comparisons can only be meaningful if the data is truly comparable

It is challenging to achieve comparability between different companies, even in the same industry. The different depreciation methods, the different inventory valuation methods used, the different policies regarding the capitalization of certain expenses make it very difficult to arrive at financial statements that can be meaningfully compared.

But even comparisons of different periods within the same company can be difficult. I have seen many small businesses with high turnover of the bookkeeping / accounting position and my review of the ledger often revealed that there was inconsistency in the way these different people accounted for many transactions. This would make the comparisons less valuable than they might be otherwise. This brings us back to our first point: accounting records must be not only accurate but also consistent.

The ratio analysis reflects only what is in the financial statements

Obviously, the financial ratios will reflect only what is contained in the financial reports of the company. And as valuable as it is, it doesn’t capture many factors that 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 company that had just been bought by an international player. The president received a certain ratio as a target for salary costs from his accounting department. Based on this ratio, you couldn’t add a single person to your accounting staff. On the contrary, to reach the goal, you would have to let some people go first.

But that did not take into account the particular situation in which this company found itself. Due to historical reasons, the staff had very low qualifications, the systems were old, and the only way out was to bring in a strong full-time controller or CFO to reorganize the department. The target ratio would not allow it. But it was the best that could be done under the circumstances. Smart leadership will recognize such ratio limitations and make the right business decisions anyway.

Other factors not contained in the financial statements may be technological developments, competitor actions, government actions, etc. All items with a potential impact on the business need to be evaluated when making important decisions, not just financial ratios.

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