Question

What can be learned about the health of a company using ratio analysis?  Garrison, Noreen, and Brewer (2018) state, “Ratios should not be viewed as an end, but rather as a starting point” What is meant by that?

Answer 1

This may be contrary to everything you have ever learned. But, think about it. Do you want high performance for your company? Or do you want average performance? I think all business owners know the answer to that one. We all want high performance. So benchmark your firm's financial ratios to those of high performing firms in your industry, and you will shoot for a higher goal.

As for a limitation of ratio analysis, the only limitation is if you use average ratios instead of the ratios of high-performance firms in your industry.

Two sources of industry average data, as well as financial statement data you can use for free, are BizStats and BizMiner. Use these to better work your ratio analysis.

  

Ever wonder why you always hear that balance sheets only show historical data? This is why. A balance sheet is a statement of a firm's financial condition at a point in time. So, looking back on a balance sheet, you see historical data. Inflation may have occurred since that data was gathered and the figures may be distorted.

Reported values on balance sheets are often different from "real" values. Inflation affects inventory values and depreciation; profits are affected. If you try to compare balance sheet information from two different time periods and inflation has played a role, then there may be distortion in your ratios.