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The ratios are symptoms rather than problems. Thus, we see the emergence of ratios as a diagnosis tool rather (Johnson, 2008). These tools must then be used in concert with more in-depth analysis techniques and the collect and interpretation of other information. Ratio analysis alone will yield little and the prevailing thought today supports finding better ways to integrate ratio analysis within the context of overall understanding of a firm's situation (Dess, et al., 2004).
Historically, the development of ratio analysis as a technique has been ad hoc. As a result, one of the steps taken in recent years, albeit more by academics than professionals, has been to attempt to develop a consistent system for conducting ratio analysis. Nissim & Penman (2001) developed a framework for such a system. Ratios are used in the context of a hierarchy, based on the ability of a given ratio to predict financial failure and their correlation with equity valuation.
There has also been a substantial amount of work with regards to detailing the usefulness of ratios in different industries. Regulators of the financial services business, which utilizes a non-standard set of financial ratios, have worked to understand the best means for using ratio analysis techniques in their industry (Bauer et al., 1997).
Financial ratio analysis is generally considered to be a worthwhile tool for investors and creditors to determine the financial health of a company, or two compare different companies with one another. It is easy to use and can provide valuable insight. Its benefits have been widely studied and there is a substantial body of work demonstrating the usefulness of different ratios in different situations. What are less often examined are the limitations of financial ratio analysis. There is danger in viewing this tool as being almighty -- it has many limitations that must be overcome. The ratios are a distillation of reams of data, and as such are subject are not always an accurate reflection.
The study of financial ratios in recent years has slowly drifted towards the issue of limitations, and how to derive stronger models by which to use ratios. The flexibility of ratio analysis, however, is one of its strong suits. Each user is free to develop models and interpretations that meet his or her specific needs. As a result, the practical application of financial ratio analysis remains every bit as ad hoc as it has historically been. General use information is widely available, but lacks critical analysis of the technique's limitations, which may encourage misuse. This does not entirely negate the value of ratio analysis, but it calls into question the degree to which it should be encouraged among the general public today.
No author. (2009). Limitations of Ratio Analysis. NetTOM. Retrieved June 24, 2009 from http://cbdd.wsu.edu/kewlcontent/cdoutput/TOM505/page26.htm
Horrigan, James O. (1965). Some Empirical Bases of Financial Ratio Analysis. The Accounting Review. Vol. 40, No. 3, pp.558-568.
Loth, Richard. (no date). Financial Ratio Tutorial. Investopedia. Retrieved June 24, 2009 from http://www.investopedia.com/university/ratios/
Johnson, David. (2008). Ratio Analysis: Highlighting the Story Within the Numbers. TMA. Retrieved June 24, 2009 from http://www.turnaround.org/Publications/Articles.aspx?objectID=8979
Nissim, Doron & Penman, Stephen H. (2001). Ratio Analysis and Equity Valuation: From Research to Practice. Review of Accounting Studies. 2001, No. 6 pp. 109-154. Retrieved June 24, 2009 from http://www.columbia.edu/~dn75/Ratio_analysis_and_equity_valuation_From_research_to_practice.pdf
Bauer, Paul W.; Berger, Allen N.; Ferrier, Gary D. & Humphrey, David B. (1997). Consistency Conditions for Regulatory Analysis of Financial Institutions: A Comparison of Frontier Efficiency Methods. Federal Reserve Bank of Cleveland. Retrieved June 24, 2009 from http://www.federalreserve.gov/pubs/feds/1997/199750/199750pap.pdf
Paulson & Huber. (2000). The Technology M&A Guidebook. Retrieved June 24, 2009 from http://books.google.com/books?id=PQSLJS445R4C&pg=PA68&lpg=PA68&dq=financial+ratio+analysis+benefits&source=bl&ots=EgpsuDlnAt&sig=BgfZOPek0BztjBVCc4o6uIV9pnE&hl=en&ei=KDBCSvbYIs3K_gaWzsCdDQ&sa=X&oi=book_result&ct=result&resnum=7
O'Connor, Melvin C. (1973). On the Usefulness of Financial Ratios to Investors in Common Stock. The Accounting Review. Vol. 48, No. 2, pp.339-352.
Salmi, Timo & Martikainen, Teppo. (1994). A Review of the Theoretical and Empirical Basis of Financial Ratio Analysis. Finnish Journal of Business Economics. 4/94, pp. 426-448.
Dess, Gregory; Lumpkin, G.T. & Taylor, Marilyn L. (2004). Strategic Management. Retrieved June 24, 2009 from http://books.google.com/books?id=804wVMgC6l8C&pg=PA95&lpg=PA95&dq=financial+ratio+analysis+benefits&source=bl&ots=ePWqbMCHua&sig=klNnm4Uis4epZEHxSpUaTHnymY4&hl=en&ei=mjJCSpSDJsSg_AblurHHCA&sa=X&oi=book_result&ct=result&resnum=10[continue]
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