Limitations of Financial Ratios

Financial ratios serve as a way of interpreting numerical data found in financial statements. As a recognized measure of a company's financial health, such ratios prove useful for delving deeper into a firm's situation, but people looking at ratios for insight should proceed with caution, so as not to draw the wrong conclusion from the calculations.

Different Policies

Management's choice of accounting policies--the specific principles and methods of preparing and presenting financial statements--may have a significant effect on key ratios.

Historic Data

Ratios, calculated using past data, don't provide complete information for future forecasting.

Creative Accounting

Creative accounting involves the use of questionable accounting techniques--such as shipping unusually large quantities of product near the end of the year or failing to write down inventories that have declined in value--to produce a desired result.

Using Different Formulas

Managers can calculate ratios using different formulas. For example, when calculating gearing--the ratio of debt to capital available--companies can choose from more than one valid approach. Only using the same method ensures a valid comparison, however.

References

• Investopedia: Financial Ratio Tutorial
• Financial Modeling Guide: Limitations of Financial Ratios Modeling
• StockTrades.ca: The Limitations of Financial Ratios