Dear Professor Cram:
Can you explain to me the concept of ratio analysis and the limitations of ratio analysis? Thanks!
Ken S., Hong Kong
Thanks for your question, Ken. In Finance, ratio analysis is generally used to compare the performance or position of a single company with other companies or with an industry.
There are several groups of ratios that each serve different purposes:
- Liquidity Ratios provide measures of how easily a firm can meet its obligations.
- Profitability Ratios indicate the earnings and profitability potential of a company.
- Asset Management Ratios measure how efficently a company can turn its assets into sales.
- Debt Management Ratios indicate how leveraged a company is in terms of debt, and how well it can handle that debt with its assets and operating income.
- Dividend/Market Value Ratios measure how well a company uses its assets to generate earnings for its investors.
Ratios can provide meaningful comparisons of companies in similar industries or of a company in a single industry. As such, financial ratios should be evaluated in comparison to other companies in the same industry. For example, a dividend ratio of 5.2 means nothing by itself, and means very different things if the industry average is 22.5 as opposed to 1.5. For businesses that have operations in more than one industry, ratio analysis is less meaningful.
Also, keep in mind that ratio analysis does not tell the entire story. There may be good business reasons to support management's decision to reduce or increase liquidity or fixed assets in a different manner than the rest of the industry. Having a single ratio out of line with an industry, therefore, does not necessarily mean there is a problem.
Here is an overview on Ratio Analysis.
Good studying,
Professor Cram
Keywords: Asset Management Ratios, Concept and Limitations, Debt Management Ratios, Dividend or Market Value Ratios, Finance, financial analysis, financial ratio, financial ratio analysis, financial ratios, Limitations, limitations, Liquidity Ratios, Profitability Ratios, Ratio Analysis, Ratio Analysis: Concept and Limitations, ratios
Comments
Hi, Rita,
I think there are more than 3 limitations of ratio analysis unless that is some specific way to group limitations. With fundamental analysis you are looking for earnings and value in relationship to risk. I haven't even dealt with issues relating to risk, but here are four areas of limitations of ratio analysis.
The bottom line is that financial ratios are great tools, but they aren't the only one in your toolbox. (You can't build a house with just a hammer, no matter how good it is!) Check the ratios, review the annual report for extenuating circumstances, and you'll soon be able to craft the big picture. Financial ratios won't necessarily give you all the answers, but they will help to ask the right questions.
Dear Profesor Cram,
Please explain to me what is the the Performance ratio? Is stock turnover included in performance also? What about Debtors collection period and Creditors repayment period? Thanks!
Dear Professor Cram,
What is the concept of profitability? There are included mark up, margin and return on capital employer(ROCE). Thanks