Using Financial Ratios for Analysis

Financial statement analyses can yield a limited view of a company because of accounting, market, and management related limitations of such analyses.

LEARNING OBJECTIVE

Describe the limitations associated with using ratio analysis

KEY POINTS

Ratio analysis is hampered by potential limitations with accounting and the data in the financial statements themselves. This can include errors as well as accounting mismanagement, which involves distorting the raw data used to derive financial ratios.
Proponents of the stronger forms of the efficient-market hypothesis, technical analysts, and behavioral economists argue that fundamental analysis is limited as a stock valuation tool, all for their own distinct reasons.
Ratio analysis can also omit important aspects of a firm's success, such as key intangibles, like brand, relationships, skills and culture. These are primary drivers of success over the longer term even though they are absent from conventional financial statements.
Other disadvantages of this type of analysis is that if used alone it can present an overly simplistic view of the company by distilling a great deal of information into a single number or series of numbers that may not provide adequate context or be comparable across time or industry.

TERM

valuation
The process of estimating the market value of a financial asset or liability.

Limitations of Financial Statement Analysis

Ratio analysis using financial statements includes accounting, stock market, and management related limitations. These limits leave analysts with remaining questions about the company.

First of all, ratio analysis is hampered by potential limitations with accounting and the data in the financial statements themselves. This can include errors as well as accounting mismanagement, which involves distorting the raw data used to derive financial ratios. While accounting measures may have more external standards and oversights than many other ways of benchmarking companies, this is still a limit.

Ratio analysis using financial statements as a tool for performing stock valuation can be limited as well. The efficient-market hypothesis (EMH), for example, asserts that financial markets are "informationally efficient. " In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made. While the weak form of this hypothesis argues that there can be a long run benefit to information derived from fundamental analysis, stronger forms argue that fundamental analysis like ratio analysis will not allow for greater financial returns.

In another view on stock markets, technical analysts argue that sentiment is as much if not more of a driver of stock prices than is the fundamental data on a company like its financials. Behavioral economists attribute the imperfections in financial markets to a combination of cognitive biases such as overconfidence, overreaction, representative bias, information bias, and various other predictable human errors in reasoning and information processing. These audiences also see limits to ratio analysis as a predictor of stock market returns.

At the management and investor level, ratio analysis using financial statements can also leave out a number of important aspects of a firm's success, such as key intangibles, like brand, relationships, skills, and culture. These are primary drivers of success over the longer term even though they are absent from conventional financial statements.

Other disadvantages of this type of analysis is that if used alone it can present an overly simplistic view of the company by distilling a great deal of information into a single number or series of numbers. Also, changes in the information underlying ratios can hamper comparisons across time and inconsistencies within and across the industry can also complicate comparisons.