Hedge Funds and Money Laundering
Money laundering is a heinous crime. Although it does not directly lead to loss of human lives, it allows money to reach the hands of wrong individuals. The proceeds from money laundering end up in the hands of gangsters, warlords, drug dealers and terror groups. No financial institutions would want to enable such transactions. However, […]
Price to Sales Ratio – Formula, Meaning, Assumptions and Interpretation
Formula Price to Sales Ratio = Current Market Price / Reported Sales Revenue Many companies state their revenue after removing the effects of onetime events whereas others continue to state the revenue without any adjustments. Meaning The price to sales ratio tells an investor how many dollars they are paying for every dollar that the […]
Strategic Capital Budgeting
The capital budgeting process is at the heart of the financial decision-making which takes place in any organization. However, up until now, the capital budgeting decision has been considered to be a financial decision. As a result, the evaluation of projects and the capital allocation process are based on discounted cash flow analysis. Many organizations […]
Money Markets vs. Capital Markets
Financial markets are markets where financial instruments or securities are traded. Financial markets can be classified based on various parameters. In order to understand the types of financial markets, we need to first understand the broad categories in which it is subdivided. The broadest classification divides financial markets into two types’ viz. money markets and […]
Common Stock Valuation: The Two Approaches
Ever since the inception of corporation as a separate legal entity, the common stock has become one of the most important financial instruments in the world today. When people commonly refer to the “market”, they are usually referring to the stock market. For laymen, investing is synonymous with stocks. Yet the average person does not […]
Ratio analysis, without a doubt, is amongst the most powerful tools of financial analysis. Any investor, who wants to be more efficient at their job, must devote more time towards understanding ratios and ratio analysis. However, this does not mean that it is free of limitations. Like all techniques, financial ratios have their limitations too. Understanding the limitations will help investors understand the possible shortcomings with ratios and avoid them. Here are the shortcomings:
The first and foremost threat to ratio analysis is deliberate misleading statements issued by the management. The management of most companies is aware that investors look at certain numbers like sales, earnings, cash flow etc very seriously. Other numbers on the financial statements do not get such attention. They therefore manipulate the numbers within the legal framework to make important metrics look good. This is a common practice amongst publicly listed companies and is called “Window Dressing”. Investors need to be aware of such window dressing and must be careful in calculating and interpreting ratios based on these numbers.
Comparison is the crux of ratio analysis. Once ratios have been calculated, they need to be compared with other companies or over time. However, many times companies have accounting policies that do not match with each other. This makes it impossible to have any meaningful ratio analysis. Regulators all over the world are striving to make financial statements standardized. However in many cases, companies can still choose accounting policies which will make their statements incomparable.
Comparison over time is another important technique used in ratio analysis. It is called horizontal analysis. However, many times comparison over time is meaningless because of inflation. Two companies may be using the same machine with the same efficiency but one will have a better ratio because it bought the machine earlier at a low price. Also, since the machine was purchased earlier, it may be closer to impairment. But the ratio does not reflect this.
Financial ratios are established “thumb of rules” about the way a business should operate. However some of these rules of thumb have become obsolete. Therefore when companies come with a new kind of business model, ratios show that the company is not a good investment. In reality the company is just “unconventional”. Many may even call these companies innovative. Ratio analysis of such companies does not provide meaningful information. Investors must look further to make their decisions.
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