Financial Ratios: Factors and Limitations

Subject: Finance
Pages: 3
Words: 572
Reading time:
2 min

Financial ratios serve as a quick method of analysing the financial performance of a business entity and thus they are regularly used by managers in decision-making. There is a number of different stakeholders, such as the management, employees, creditors and potential lenders, who use financial ratios to identify the strengths and weaknesses of a company. However, there are internal and external factors that should be taken into account when relying on these metrics.

Internal factors refer to the quality of financial statements and their reliability and a company’s choice of accounting policies used in financial statements. For example, if one company uses the last-in-first-out valuation and another one uses the first-in-first-out valuation, their financial ratios will be not comparable. Also, if managers use creative accounting (or fraudulent accounting, which is worse) to make investors believe that a company looks healthier, financial ratios cannot be used for productive decision-making. This may lead one to another internal factor influencing the utilisation of the ratio analysis, which is the quality and experience of the management team.

Since ratios are based on financial statements, the quality of these statements inevitably influences the quality of the ratios. Another internal factor is the comparison of the current year ratios to the previous year ratios. External factors which should be considered in managerial decision-making include the state of the economy, the context of financial ratios and differences in the scale of business entities that are compared using financial ratios. Other external factors may include lower and senior management changes.

The first limitation of the ratio analysis refers to all the intrinsic limitations of financial statements that are reflected in financial ratios. For example, financial statements fail to include all resources controlled by the business. That is why internally-generated goodwill is excluded from the statement of financial position as it does not correspond to the strict definition of an asset. As a result, no matter how great the value of these resources may be, they are not taken into account in ROSF, ROCE and the gearing ratios.

The second persistent limitation is inflation which distorts the financial results of businesses. Due to inflation, the reported value of assets for a certain period cannot be adequately compared to current values. This is because assets are usually reported at their current price less the amount of depreciation. The given limitation also relates to the measurement of profit. Due to inflation, expenses may not reflect prices that are current at the time of the sale. The reason for this is that profit is calculated as the cost of sales less the costs incurred and there is a time period between these two values. As a result, in the income statement, expenses will be understated and the profit will be overstated.

The third limitation is the basis for comparison which is required to compare ratios. The greater is the differences between the organisations being compared, the greater are the limitations of ratios comparison. The fourth limitation is the statement of financial position ratios which are only a “snapshot” of a business during a particular period. That is why some ratios, for example, liquidity ratios, may not represent the financial position of a business for a year as a whole. In this case, additional measurements are needed in order to get a clearer picture of liquidity.