Question

What are the Advantages and Disadvantages of Financial Ratios?

Answer 1

Financial ratios are one of the most commonly used tools for measuring different performance parameters of a company.

These ratios are used to benchmark a company against its peers in the industry or benchmark the present parameter against its historic trends.

The key advantages of using financial ratio are

1)It provides an easy snapshot of the various parameter of the company rather than looking at the raw financial data.

2) It helps the analyst to understand and identify trends that are unique to industry/sector eg: typically IT sector has low debt to equity ratio compared to capital intensive sectors like cement and steel

3)It allows easy comparison of the different companies within the sector and identify outliers. It is especially helpful when the scale and size are different which is otherwise difficult to understand.

eg-Comparison of a large cap company and small cap company in the same sector with similar line of business would otherwise difficult to compare due to difference in scale of operation.

Financial ratios do have limitations like

1) Since these ratio are based on information in financial statement , so change in accounting parameters can significantly vary the ratio. Like change in depreciation policy or change in inventory calculation across different company may result in ratio not reflecting true standing.

2) Comparing historic trends may need to be adjusted to reflect the change in regulatory/ business environment that has occured over a period of time. eg- increase in tax rate would reduce over all net profit ratio if the increased burden could not be passed to the customer.

3)It is important that correct peers and companies are selected as difference in capital structures and different operating model (eg leasing of capital asset vs buying of capital asset) can result in varied financial ratios.

4) Financial ratios are usually calculated basis past performance and most of the times are not future looking and do not provide future outlook.(exception - forward P/E ratio or ther market linked forward ratios)