Ratios seem so precise but they are based on historical information which has been arrived at using subjectively calculated numbers. In most cases aggregated numbers are used which can be misleading. History does not necessarily predict the future with any accuracy.
(1) Accounting information is the result of subjective judgements. Not all firms use the same methods and techniques in drawing up final accounts. The valuations which are placed on current assets such as stock and debtors, are the best opinions of the directors or management of the company. Stock valuation methods may vary. Opinions may differ as to the accounting treatment of certain expenses and income. For example, does one capitalise the interest expense on an installment sale purchase agreement and depreciate it together with the asset, or write it off as an interest expense over the period of the agreement?
(2) Assets are not always valued at current replacement cost. Fixed assets are usually shown in the balance sheet at cost, and the depreciation on those assets may be based on book value. The true value may be very different. Asset values may therefore differ from company to company. Assets are valued in the business ‘as a going concern’ and the amounts realised may differ considerably if disposed of on a forced sale basis
(3) Although the ratios are numeric, they may not always be precise. Even though ratios can be calculated to several decimal places, this does not mean that they are the last word in an analysis. Inferences drawn from inaccurate data will not be valid. One should look behind the ratios and make a judgement as to the accuracy of the base data.
(4) Past performance is not always a guide to future performance. There may be changes in management, economic and business conditions and accounting methods. Despite this, past data can give clues to a trend which may continue in the future.
(5) Ratios must be relevant to the type and nature of the business. One should make comparisons with the ratios of other businesses in the industry. The establishment of acceptable norms is difficult even if industry averages are available. For example, comparisons are difficult between companies that have policies, e.g. leasing rather than buying. A company should not be complacent about a favourable comparison with a similar company in the industry. There could be problems within the company that are shared by the other company. Each set of ratios should be viewed in their own right.
(6) Financial statements at different dates may not be comparable. Ratios are usually calculated based on financial statements drawn up at the end of the accounting period. Fluctuations during the year are often hidden. Financial statements are sometimes ‘window dressed’ to show a better picture. An example would be the running down of stock by large credit sales at the year end to improve the quick (acid test) ratio and the stock turnover.
(7) Various ratios may sometimes be quoted in the annual financial statements. These must not be accepted at face value - the basis of calculation must be checked. Two different annual financial statements may quote the same ratio, but use a different basis for calculation.
Despite the above limitations, ratios are very useful indicative guides to establishing what has happened in a business, how healthy it is financially, and what its future performance trends are likely to be. What the limitations do emphasize are that analysts should use skill and judgement to interpret the ratios calculated. The following will help to develop the flair for sound analysis:
- Select those ratios that are important to the investigation. There is no necessity to calculate every possible ratio. A limited number will usually suffice. Different ratios often reveal similar things.
- Calculate ratios for more than one period. A computer model can be very useful if many ratios have to be calculated.
- Set out the information in an easy-to-read format. Tables, graphs and summaries make interpretation much easier. The more significant ratios can be highlighted and comparisons made to industry averages, past trends of the business, or ‘rule of thumb’ values.
- Investigate anything that appears unusual or inconsistent by calculating other ratios or examining the basic data.
- Investigate the circumstances that gave rise to any variations or inconsistencies.
SOURCE: Business Accounting & Finance for Managers & Business Students - 1996 Authors: John Bradshaw and Mel Brooks