Advantages & disadvantages of financial ratios

Written by catherine capozzi
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Advantages & disadvantages of financial ratios
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Investors and businesses use financial ratios to gain better insight into the health of the company. Each ratio offers a different perspective into the business operations: The inventory turnover ratio, for instance, specifies how quickly a company sells and replaces its inventory. The current ratio illustrates the company's amount of assets compared to its liabilities, which indicates its ability to pay its debts. These ratios are beneficial in some cases but lack sufficient information in other cases.

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Business Operations Improvements

Lawrence Gitman and Carl Daniel, authors of the book, "The Future of Business: The Essentials," explain that ratios help managers monitor the progress of the company's operations and identify potential weaknesses. The specificity of some ratios allows companies to rely on them for guidance on improving its business operations. For instance, the accounts receivable turnover ratio indicates the company's ability to issue credit and collect from its debtors. A weak ratio may compel the company to reassess its lending practices or reign in its issuance of credit. Similarly, the business might assess its average collection period ratio and decide it needs to hire additional collectors to improve its receivables.

Potential/Future Events

Ratios fail to address the potential of the company, as they only offer insight to the business's present situation. For instance, if the company is about to merge and acquire large amounts of capital, the ratio will not reveal these new changes. If a corporation publishes to its investors that it is about to lose its main client effective in two months, no ratio will indicate the bad news. Therefore, ratios cannot be the only measurement investors use to assess a company's value because these numbers do not reveal other key information such as potential industry changes and economic forces.

Considerations

Investors should not rely too much on ratio numbers as a measurement of the overall company's health. Some ratios may indicate the company is in good health while another may indicate financial dire straits. Therefore, investors need to assess multiple ratios to get a holistic picture of the company's stability. Battacharyya, author of the book, "Essentials of Financial Accounting," suggests using financial statement analyses in tandem with financial and non-financial ratios to gain a complete picture of the business.

Factors

Ratios are advantageous to some parties but not always to others. A bank may not care about a company's book-to-market ratio, but financial institutions will evaluate its level of debt and liquidity ratios to determine if the company is worthy of a loan. Similarly, because finding a new vendor is costly, a large company such as Wal-Mart may look at a potential vendor's liquidity ratio to check its stability.

Warning

Using different accounting methods can alter the numbers calculated in the ratio. For instance, debt is easily disguised by placing certain liabilities in different accounts or shell companies. Therefore, you should consult multiple external sources such as newspapers and magazines when assessing the value of a company.

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