Strengths and Weaknesses of Ratio Analysis

Ratio analysis can reveal most of the information about the company when it is used effectively. An analyst must be aware of the strengths and weakness of this method for correct assessing these values. Following explains the strengths and weaknesses of this method.

Strengths

Ratio analysis can be very helpful when the values are compared against previous years, other companies, industry averages. These comparisons help analyst to identify company’s strengths and weaknesses and evaluate its financial position and also foresee the risks that may emerge in the future.

Using ratios a financial analyst can implement plans to improve profitability, liquidity, gearing problems and market value of the business. Although ratios report on past performances, they can be used for predictive purposes to catch potential problems. It is possible to verdict if the company has enough liquidity to pay its future debts or even tell whether its shareholders will be happy.

Weaknesses

Not all financial ratios can be compared. There are several points that analyst must take into account. When two companies' financial data is compared, the ratios must reflect comparable price levels and these values must be evaluated using same accounting methods and valuation bases. Also, such comparisons should be limited to companies engaged in similar business activities. If the financial policies differ, this must be recognized while evaluating of comparative reports. For example one company leases its properties while the other purchases such items; one company finances its business using long-term borrowing while the other provide its fund by shareholders and reserves. In these cases, ratios can not be compared.

Comparing ratios with past data of the same company (trend analysis) can indicate the performance over years and highlight points that need for action, however it will not be enough to tell much about the company’s status among competitors. For more informative analysis, ratios should be compared with two or more companies in similar line of business (cross-sectional analysis). More reasonable method would be comparing ratios to industry averages, which are developed by statistical services and trade associations.

There is no single or correct value for a ratio. The value may be too low or to high against to reference value. Ratios may mislead when they are not combined with company’s management and economic circumstances. Analyst must consider company’s products, competitors and also the company’s vision for the future.

In the trend analysis although 2 years comparison can give the idea about the performance of the company, it is best to use three to five years of ratios to have broader view of performance. Seasonal variations also must be looked at attentively in trend analysis.

Another point about ratios is that they could be evaluated with different methods and they are dependent on the perspective of the analyst. Therefore it is not always possible to define “good” and bad for the values.