Different Types of Contracts for Infrastructure Projects
Private-public partnerships are a common mechanism used while creating infrastructure projects. In general, a public-private partnership involves a joint venture between a government body and a private corporation. However, there are several different ways in which it is possible for these two types of companies to collaborate. In some types of contracts, the government bodies […]
The Financial Disadvantages of Retail Warehouse Automation
In the previous few articles, we have already seen what retail warehouse automation is. We are now aware of the different degrees of retail warehouse automation which is prevalent in the industry. We also know that such automation is very popular because there are several financial advantages which arise from such automation. However, it would […]
Cash Flow Types in Fixed Income Securities
The first thing that any investor related to fixed income markets first notices about the market is the sheer variety of the instruments being traded. A large variety also means that the trading in bonds becomes more complex. Investors need to understand the different types of fixed-income securities that are available in the market. Fixed […]
Behavioral Portfolios
There is a fundamental difference in the way portfolios are viewed in traditional financial theories and the way in which they are viewed in behavioral finance. At the technical level, a portfolio is nothing but a collection of investment instruments such as stocks, bonds, real estate, etc. However, the purchase of these instruments and the […]
What is Prime Brokerage ?
History of Prime Brokerage The growth in the number of hedge funds as well as the scale of their operations quickly created the need for a special kind of intermediary that would cater to their needs. This intermediary was the “prime broker”. The prime brokerage business quickly caught the attention of many investment banks as […]
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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