Limitations of Financial Ratio examination
I am a big fan of ratio examination for small business owners. I don’t have to inspire large company CFOs and Controllers to perform ratio examination, because it is their daily bread, but I find that many small business owners have not however attained an appreciation of what financial ratios can do for them.
But as much as ratio examination can help you, it can also mislead, so I thought it would be good to delve into the limitations of financial ratio examination today.
Ratio examination can be only as good as the inner data
Ratios are absolutely wonderful. They boil down a complicate set of numbers and relationships to a simple, 1 or 2 digit number which tells you volumes! But beware… What if those complicate, inner data are not accurate? Many important decisions are made because a ratio has changed by 1 or 2 percentage points. Given that, your accountant better make really sure that the calculations can be relied upon.
In the small business ecosystem things like reconciled trial balance (yes, not only the bank accounts!) and monthly, reviewed financial statements cannot be taken for granted. Many small businesses do not have adequate accounting systems in place nor do they all have competent accounting personnel making sure the monthly financial results are not only obtainable, but truly accurate.
Calculating any ratios based on questionable data and an unreconciled set of books can be very dangerous. So, before any examination is already attempted, the accounting records must be brought up to par.
Ratio comparisons can be meaningful only, if data is truly comparable
It’s a challenge to unprotected to comparability among different firms, already in the same industry. Different depreciation methods, different inventory valuation methods used, different policy regarding capitalization of certain expenditures make it very hard to arrive at financial statements which can be compared meaningfully.
But already comparisons of different periods within the same company can get tricky. I have seen many small businesses with a high turnover of the bookkeeping/accounting position and my review of the general ledger revealed often that there was no consistency in the way many transactions were posted by those different people. This would make comparisons less valuable than they could otherwise be. This brings us back to our first point – accounting records need to be not only accurate but also consistent.
Ratio examination reflects only what is in the financial statements
clearly, financial ratios will mirror only what is contained in the financial reports of the company. And as valuable as that can be, it does not capture many factors which can have a profound impact on the business and however cannot be quantified or expressed in accounting terms.
I remember acting as a part-time controller for an insurance firm which has just been purchased by an international player. The President was given a certain ratio as a target for his accounting department salary costs. Based on this ratio, he couldn’t add a single person to his accounting staff. On the contrary, to meet the target, he would have to let some people go first.
But that didn’t take into consideration the particular situation this company was in. Due to historical reasons, the staff had very low qualifications, systems were old and the only way out was to bring a strong complete-time controller or CFO to reorganize the department. The target ratio wouldn’t allow for that. But it was the best thing to do in those circumstances. Intelligent leadership will recognize such limitations of ratios and make the right business decisions anyway.
Other factors not contained in the financial statements can be technological developments, competitor’s actions, government actions, etc. All elements with possible impact on the business need to be evaluated when making important decisions, not only financial ratios.
nevertheless, financial ratio examination is a meaningful part of those decisions and I would venture to say that a company which doesn’t avail itself of this information is at a disadvantage.