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 the performance or for comparison purposes. There are several characteristics of ratio analysis that make it one of the most popular financial analysis tools for newbies and professionals alike. 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 user of the financial statement. 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 for a better understanding of the financial statements’ figures.
Otherwise, it is subject to misinterpretation. These are some of the pitfalls of ratio analysis as a financial analysis technique.
Limitations of Ratio Analysis as 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.
While financial ratios can be a helpful tool for investors and analysts, it is important to remember that they are only one piece of information that should be considered when making investment decisions.