Question

Why is sole reliance on financial ratios an ineffective means of deriving internal strengths and weaknesses?

Answer 1

When we rely only on financial ratios, it becomes difficult in deriving internal strengths and weaknesses. We won't be able to know whether the sources of income are from core business or other sources. We should not depend only on financial ratios. We have seen many companies doing accounting frauds. Financial ratios are numbers that are derived from the financial statements. If financial statements have accounting frauds, then the financial ratios will be misleading.
Accounting practices can differ from one firm to other and in that case comparing financial ratios might not give the expected results.
Financial ratios are mostly based on historical cost which we cannot use to measure financial performance of companies.
Most of the items in the financial statements are subjective like calculation of impairment gain/loss, receivables quality, asset valuation etc, without understanding how a company has estimated the subjective items and directly looking for financial ratios and comparing them with peer companies won't give correct results.
Manipulations through creative accounting also leaves no meaning for the use of financial ratios.
We normally compare the financial ratios of a company with the industry average, however every company in the industry will have their own characteristics.
Instead of relying only on financial ratios, we should look at the management discussions, footnotes, other required items given in financial reports.