Financial Management: Weaknesses of Ratio

Financial Management: Weaknesses of Ratio Analysis

In basic terms, financial ratios are used by a wide range of stakeholders for various purposes. For instance, while creditors can use liquidity ratios to determine an entity's ability to settle its obligations in the short-run, investors could utilize profitability ratios in an attempt to measure how successful an entity is especially in regard to profit generation. It is however important to note that regardless of the usefulness of financial ratios, they also have a number of key weaknesses.

Financial Ratios: A Concise Definition

Financial ratios are the key tools of financial statement analysis. Depending on what they measure (or what they purport to measure), financial ratios can be grouped into various categories, i.e. profitability ratios, liquidity ratios, etc.

Weaknesses and Limitations of Financial Ratios

As I have already pointed out, regardless of their relevance when it comes to financial statement analysis, financial ratios have a number of limitations or weaknesses. To begin with, Siegel and Shim (2006) point out that diversity in the application of GAAP could effectively lead to a distortion of the ratios computed. In this case, the authors give an example of a firm using FIFO while another deems it fit to utilize LIFO in inventory valuation. In such a case, the conclusions drawn from the ratios computed would most likely be erroneous. Closely related to this, it should also be noted that as Siegel and Shim (2006) point out, the actual components of the said ratios are not usually revealed. For instance, in the words of the authors, "the current ratio may be high but inventory may be composed of obsolete merchandise and receivables may include accounts owed from a politically unstable foreign country" (Siegel and Shim, 2006). In such a case, the said ratio cannot be expected to show a true picture of the company's ability to settle its obligations in the short-term. In that regard, the information supplied by ratios could in some instances be faulty.

Secondly, it is also important to note that ratios are largely numerical, i.e. they ignore other key indicators and measures of financial performance. Other equally important measures and/or indicators of performance in this case include but they are not limited to employee morale, client service and satisfaction, quality of goods or products, etc.

Another key limitation of ratios is that they are only useful when it comes to the comparison of firms operating in the same industry. Utilizing ratios in the analysis of financial statements of companies in different industries could lead to a distortion of the information desired. This is more so the case given that entities in different industries are more often than not exposed to different regulations, market conditions, etc. In practice, finding two companies that are identical in every way is impossible.

Ratios could also be affected by changes in price levels. According to Lasher (2010), financial statements are often distorted by inflation. In the author's words, "during periods of rapid inflation, inventory, cost of goods sold, and depreciation can badly distort true results" (Lasher, 2010). Such changes effectively affect the comparability of financial ratios.