Taken as a whole and used with some caution, financial ratios can provide useful information about current performance and long-term viability. A careful analysis of the values calculated from the right combination of ratios may help you spot a likely failure years in advance. Despite this, financial ratios aren’t always as useful as some people may believe. Understanding the pros and cons can help in using ratios to your best advantage.
Big Results for Little Effort
Most ratios require few inputs and are easy to calculate. As a result, you can get valuable information quickly, and without an accounting degree. For example, calculating gross profit margin requires only two steps. In the first step, you determine gross profits by subtracting the cost of goods sold from gross revenues. In the next step, apply the formula (gross profits/gross revenues)*100. The higher the gross profit margin the better your business is doing.
Compare and Conquer
Financial ratios are a cost-effective way for small-business owners to make vital internal and external comparisons. Using information from financial statements, an annual budget or sales details, business owners can compare projections to actual performance, either for the business in general or for individual departments and sales people. Ratios also are useful for comparing current operational or financial performance to another company’s performance or against an industry standard. As time passes, refer back to previous results to see whether your business is improving.
Different Perspectives, Different Results
People can -- and often do -- disagree over the meaning of financial ratios. This often results from a lack of interpretation standards, but differences can also come from intentional self-deception or a lack of knowledge. Problems with interpretations can also come from using too few or too many ratios. A single ratio creates a narrow, overly simplistic picture, while using too many ratios can become so confusing that interpreting a situation accurately becomes more difficult.
Data Accuracy and Reliability Issues
Financial ratios can only be as accurate as the data used in formulas and calculations. Although a strong internal control system can create reasonable assurances that data is correct, internal controls can fail. Ratios derived from erroneous or inaccurate source data, such as raw data distorted to sway ratio results, can have disastrous consequences when used during financial analysis. One example is the Lehman Brothers scandal of 2008 in which the company disguised over $50 billion in loans as sales.