Ratio Analysis: Concept and Limitations

Posted by Professor Cram in Weblog

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:

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

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2 Responses to “Ratio Analysis: Concept and Limitations”

  1. joe says:

    hi wanted to know when using ratio analysis, firms will often compare their ratios to Industry Averages. When might this not be a good idea? can I have a specific example
    In Present Value analysis, stocks are considered a perpetuity (a constant stream of cash flows without end). Why don’t they have infinite values? Under what cases can we easily calculate their values?

    if you can assist me I will apreciate it, thank you

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