To conclude the series on Financial Ratios, we will evaluate the disadvantages of using it.
1] Insufficient Data for Comparison
Depending on the industry that your business operates in, there may not be sufficient historical data available in order to make a meaningful comparison. It is possible that your business might be so niche that there are not enough other entities operating in that sector to allow for an insightful comparison. As an example, financial information on nightclub entertainment businesses is not publicly available nor are the owners willing to share that information voluntarily.
2] Different Accounting Policies and Regulatory Environments
Comparison of ratios among entities in different sectors is hindered by the use of different accounting policies and the regulatory environment that they operate in. The most well-known example is the usage of U.S. GAAP by American businesses vs IFRS [International Financial Reporting Standards] used by Europe and the British Commonwealth countries which have very different policies for reporting revenue, expenses, assets and liabilities.
3] Window Dressing
Partly related to Point 2 above, accounting policy interpretations may be manipulated to show off the company’s performance in a favorable light. Sales numbers may be exaggerated, liabilities and expenses may be understated to boost profits. This manipulation of financial statement numbers is know as “window dressing” and must be kept in mind when comparing financial statement ratios between different businesses.
4] Quality of Data
When reading a set of financial statements, readers often assume that the numbers are free of any human or mathematical error. In practice, humans are prone to error. As analysts of financial ratios, caution must be exercised.
5] Different Business Cycles
In order to have a useful comparison of ratios, ideally you would need the companies that are being evaluated to have the same business cycles, have the exact same financial year-ends, and have been operating in business for approximately the same length of time. In practice, this happens very rarely. Comparing the results of a junior newcomer business to an established giant in an industry may not be very useful at all. “Beginners luck” can influence results. The established business may have advantages and resources that the newcomer has not yet fully built up. Every industry has a cycle where they make the majority of their money. Comparing a hotel business to a manufacturer will not be 100% useful.
6] Reader Biases
Interpreting financial ratios requires an element of neutrality in order to get the best value out of the numbers. As humans, some level of bias can creep in when reading a company’s financial statements. The same numbers can be interpreted in two different ways by two analysts. If the reader does not like the mission or the values of a particular company, then their interpretation may be clouded by their bias.
7] Inflation
Inflation can distort numbers over time and make comparison and interpretation meaningless and questionable. For example, past trends of increasing sales may be the result of great advertising campaigns driving up the number of units sold or it may be as a result of inflationary related price increases. High sales revenue in the current periods may be worth less in comparison to prior periods if adjusted for inflation. Comparing businesses that operate in hyperinflationary environments should be performed with caution.
8] Non-Qualitative Factors
Ratios only place emphasis on the numerical data. It is a very cold, objective mathematical analysis. Consequently, ratios ignore qualitative factors such as a company’s employee morale or their involvement in unsavoury environmental practices to manufacture their product, political views, and the usage of child labour in their factories.
9] Timing Lag
There is always a significant period of time that elapses between the company’s year-end date and the actual release of their financial statements. The numbers reported in the financial statements only reflect a snapshot at a particular point in time. Similarly, the ratios only reflect the business’s situation at that point in time. Time lapses can make financial information irrelevant.
The Final Word
Now that you are armed with the knowledge of all aspects of financial ratios, the smart business owner will confidently know how best to conduct their own ratio analysis in a balanced manner that will help propel their business beyond success.
All the best and good luck with your businesses !!
