Limitations of financial ratio analysis

I'm a big fan of ratio analysis for small business owners. I do not have to inspire CFOs of large companies and auditors to perform analysis of the relationship, because it is their daily bread, but I find that many owners of small businesses have not yet received the appreciation of what we can do for their financial ratios.

But as ratio analysis can help you, it can also mislead, so I thought it would be good to explore the limits of today's financial ratio analysis.

Analysis of the relationship can be just as good as the underlying data
The reports are absolutely wonderful. It reduces a complex set of numbers and relationships for a simple, 1 or 2 digit number that tells you volumes! But be careful ... And if those complexes, the underlying data are not accurate? Many important decisions because a relationship is changed by 1 or 2 percentage points. Given that, the better your accountant to make really sure that the calculation can be invoked.

In small things as the business environment reconciled trial balance (yes, not only bank accounts!) And monthly budget review can not be taken for granted. Many small businesses do not have adequate accounting systems in place or have any competent accounting personnel that the monthly financial results are not only available, but in fact accurate.

Calculating any reports based on questionable data and a set of unreconciled books can be very dangerous. So, before any analysis is attempted, the records must be brought up to par.

Comparison report can only be meaningful if the data are truly comparable
It 's a challenge to achieve comparability between different companies, even in the same field. Depreciation methods, different methods of inventory valuation methods, different policy regarding the capitalization of certain expenses make it very difficult to arrive at a budget that can be compared in a meaningful way.

But the comparison of different periods within the same company can get difficult. I have seen many small businesses with a high turnover of accounting / financial position and my review of general ledger often revealed that there was no consistency in how many different operations have been sent by those people. This would make the comparison less valuable than it might otherwise be. This brings us back to the first point - the documents must be not only accurate, but consistent.

Analysis of the report reflects only what is in the budget
Obviously, financial reports reflect only what is contained in financial reports of companies. And the same value as that may be, does not capture many factors that can have a profound impact on business and yet can not be quantified or expressed in accounting terms.

I remember acting like a part-time control for an insurance company that has just been purchased by an international player. The president was given a certain relationship as a target for its costs of the accounting department salary. Based on this relationship, one person could not add to his personal accounts. Conversely, to achieve the goal, he should leave some people go first.

But this does not take into account the particular situation the company was in for historical reasons, the staff had very low qualifications, the systems were old and the only way out was to bring a strong full-time controller or CFO to reorganize department. The report does not allow such a target. But it was the best thing to do in those circumstances. Intelligent guidance recognizes these limitations and relationships to take business decisions right anyway.

Other factors not included in the budget may be technological developments, actions of competitors, governmental actions, etc. All elements with potential business impact should be assessed when making important decisions, not only financial ratios.

Still, financial ratio analysis is a key component of these decisions and I dare say that a society that does not make use of this information is at a disadvantage .......