Study notes

Value and Limitations of Ratio Analysis

Ratio analysis is widely used in practice in business. Teams of investment analysts pour over the historical and forecast financial information of quoted companies using ratio analysis as part of their toolkit of methods for assessing financial performance. Venture capitalists and bankers regularly use ratios to support their analysis when they consider investing in, or loaning to businesses.

The main strength of ratio analysis is that it encourages a systematic approach to analysing performance.

However, it is also important to remember some of the drawbacks of ratio analysis

  • Ratios deal mainly in numbers – they don't address issues like product quality, customer service, employee morale and so on (though those factors play an important role in financial performance)
  • Ratios largely look at the past, not the future. However, investment analysts will make assumptions about future performance using ratios
  • Ratios are most useful when they are used to compare performance over a long period of time or against comparable businesses and an industry – this information is not always available
  • Financial information can be "massaged" in several ways to make the figures used for ratios more attractive. For example, many businesses delay payments to trade creditors at the end of the financial year to make the cash balance higher than normal and the creditor days figure higher too.

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