Ratios are basically figures that represent an element’s value in terms of the other. These are some of the most used techniques of financial analysis.
Typically, ratios are used to analyse performance or for comparison purposes. Several characteristics of ratio analysis make it one of the most popular financial analysis tools for newbies and professionals. One such characteristic is a simple representation of times and percentages that almost everyone among us is familiar with.
Thus, even a layman can interpret the message behind the document analysed and read by the financial statement user. However, it only gives the final figure, but there is no clue about the other essential details. For instance, in the case of the profit margin ratio for 2 companies, A and B, A can have more margins than B, but the sales are less for A and the market price per share. These things do not get accounted for in the ratio.
Depending on a single ratio leads to an incomplete analysis based on half-knowledge only. It makes interpretation mechanical by limiting it to quantitative values. The context is not complete. However, ratios are good in providing first-hand information about the company’s performance. Other limitations include the historical data in use, open to misinterpretation by a layman, etc.
Hence, ratios are mechanical and incomplete. Non-technical users require more disclosures and ratios to better understand the financial statements’ figures.
Otherwise, it is subject to misinterpretation. These are some pitfalls of ratio analysis as a financial analysis technique.
Limitations of Ratio Analysis as an Investment Decision Tool
Investors and analysts often use financial ratios to gain insights into a company’s financial health and performance. However, financial ratios are merely a tool and should not be relied upon as the sole basis for investment decisions.
There are several reasons why financial ratios should not be relied upon as the sole basis for investment decisions. First, financial ratios are mechanical and do not take into account the underlying business conditions and trends that may be impacting a company’s financial performance. Second, financial ratios only provide a snapshot of a company’s financial health at a particular point in time and do not take into account a company’s past performance or future prospects. Finally, financial ratios should only be used in conjunction with other information, such as a company’s business strategy, competitive position, and other financial and non-financial indicators.
Ratio analysis is a very useful and efficient tool for analysing the financial data of companies. However, there are certain drawbacks to using it as an investment tool. A lot of information can be derived from a company’s financials. Hence, sometimes, investors have to make a hunch on whether the ratio analysis they are using is accurate or not.
Ratio analysis as a “decision tool” is inherently limited and must be viewed as only a component of a process for investment decision-making, not the entire process.