7.11 Some Limitations of Financial Ratios  – Introduction to Financial Analysis (2024)

As we have learned, most financial ratios consist of accounting data, which are limited in interpretive usefulness, but may be all we have. The astute analyst is aware of this and makes appropriate adjustments. The principle ofGarbage-in, Garbage-outalways pertains. Ratios are useless if the accounting data inputtedaresuspect. Here are some issues to look out for.

1. AccrualAccountingdata management:Garbage-in, Garbage-out.
2. Companies engage inReal Earnings“window-dressing” in order to make their statements appear in a certain manner; examples include pulling forward or deferring actual expenses.
3. Accounting policies differ from one firm to another, making cross-sectional analysis difficult; forexample, one company uses FIFO while another uses LIFO.
4. Ratios are “static” and do not necessarily reveal future relationships.
5. A ratio can hide problems lying underneath; an example would be a high Quick Ratio hiding a lot of bad accounts receivable.
6. Liabilities are not always disclosed; an example would becontingentliabilities due tolawsuit. Since it may – or may not –happen, the accountant will not disclose it. There has been no transaction. (This may appear in the footnotes only.)
7. Companies are often in multiple lines of business. Therefore, identifying an industry group is virtually impossible, making cross-sectional analysis ineffective.
8. Industry benchmarks (see prior page)are often only approximations, and inaccurate onesat that.Also, there are often data entry errors.