What to Watch Out for When Using Financial Ratios

Financial ratios are tools used to evaluate a company’s performance by analyzing its financial statements for insights into profitability, efficiency, and financial leverage. While these metrics are powerful, they are not infallible. Using them without understanding their inherent limitations can lead to flawed analysis and poor decisions, as the numbers presented are not always as straightforward as they appear.

Varying Accounting Policies and Estimates

A challenge in ratio analysis stems from the flexibility within Generally Accepted Accounting Principles (GAAP). Companies in the same industry can make different accounting choices that alter their reported financial results, making direct comparisons misleading. These choices reflect management’s judgment and can have a substantial impact on key ratios, requiring a review of the financial statement footnotes.

One common area of divergence is inventory valuation, where a company can choose between methods like Last-In, First-Out (LIFO) and First-In, First-Out (FIFO). During periods of rising prices, the FIFO method results in a lower cost of goods sold (COGS), leading to higher reported net income and inventory balances. This inflates profitability ratios like gross profit margin, while LIFO would report lower profit and inventory values.

Depreciation methods for long-term assets also introduce variability. A company can use the straight-line method, which spreads the cost evenly over an asset’s life, or an accelerated method that expenses more of the cost in its earlier years. Choosing an accelerated method results in lower net income and a lower book value for fixed assets initially, making a company look less profitable in the short term than a competitor using the straight-line method.

Beyond specific policies, financial results are influenced by management estimates about uncertain future events. This includes judging the useful life of equipment or determining the percentage of uncollectible accounts receivable. These subjective estimates can be managed to smooth earnings or present a more favorable financial picture, thereby affecting ratios that rely on net income or asset values.

Lack of Industry and Company Context

A financial ratio holds little meaning in isolation, as its value is derived from comparison. Comparing a company’s ratios to inappropriate benchmarks is a common error that leads to flawed conclusions. The primary question an analyst should ask is not “What is the ratio?” but “Compared to what?”

Comparing ratios across different industries is deceptive because business models and capital structures vary widely. For example, a grocery store chain operates on thin profit margins but has a high asset turnover ratio due to high sales volume. In contrast, a heavy equipment manufacturer has a lower asset turnover ratio but higher profit margins, so comparing the two would be misleading.

Similarly, regulated utilities often carry more debt than technology companies. Their stable revenue streams allow them to support higher leverage, making a high debt-to-equity ratio normal for the industry. A tech company with the same debt level might be viewed as overleveraged because its revenues are more volatile, so analysis requires comparing a company against its specific industry average.

Even within the same industry, company-specific context is important. A large, mature corporation will have different financial ratios than a small, high-growth startup, which may have negative profitability ratios for years as it invests in expansion. A company pursuing a low-cost strategy will have different margin ratios than a competitor focused on premium branding and innovation.

Distortion from Non-Recurring Items

Financial ratios are most useful when they reflect a company’s sustainable, core operational performance. However, financial statements often contain non-recurring or infrequent items that can significantly distort these calculations. These one-off events are not part of normal business and failing to account for them can create a misleading picture of profitability.

These items can include events like a large gain from the sale of a subsidiary or significant one-time expenses from a lawsuit settlement or corporate restructuring. Companies disclose these items on the income statement or in the management discussion and analysis (MD&A) and footnotes. This disclosure helps analysts identify events that are not part of core operations.

The impact of these items can be substantial. For instance, a company with mediocre income from its primary business could report exceptionally high net income if it sells real estate for a large one-time gain. This would artificially inflate profitability metrics like net profit margin and return on equity (ROE), making the company appear more profitable than it is.

To perform an accurate analysis, one must identify these non-recurring items and adjust the reported figures. An analyst should calculate a “normalized” net income by removing the after-tax effect of these one-off gains or losses. Using this adjusted figure to recalculate profitability ratios provides a clearer view of the company’s underlying earning power.

Reliance on Historical Data

A limitation of financial ratio analysis is its reliance on historical data from past financial statements. Consequently, ratios reflect what has already happened and are a report card on past performance, not a guaranteed predictor of future results. This backward-looking nature is a constraint to keep in mind when evaluating a company.

Excellent historical ratios do not ensure future success, as a company’s landscape can be rapidly altered by factors not reflected in past data. Historical performance can become an unreliable guide due to:

• The emergence of a disruptive technology
• A sudden shift in consumer preferences
• The entry of a powerful new competitor
• A significant change in the regulatory environment

A company with a history of strong profitability could see its margins evaporate quickly in the face of such changes.

Ratio analysis is only a starting point and must be supplemented with a forward-looking, qualitative assessment. This involves analyzing a company’s business strategy, management team, competitive advantages, and broader industry trends. This provides a more complete picture than numbers alone.

A comprehensive analysis integrates the story told by historical numbers with an evaluation of future potential. For example, a company may have declining profitability ratios while investing in a promising new product line. Conversely, a company with stellar current ratios may face a threat from a new market entrant, so combining quantitative and qualitative analysis is necessary for a reliable picture of a company’s health.