Step Up Bonds: Pros and Cons
Step-up bonds are special types of fixed income instruments. They help investors partially offset the risks of rising interest rates. This is because when investors invest in a bond, they typically lock in an interest rate. If the interest rate rises beyond that number, then the investors are at a loss because their money has […]
What is Annuity? – Meaning and Concept
An annuity, just like a perpetuity, is a shortcut used while making present value calculations. Unlike the perpetuity, which is very difficult to find in real life, we find examples of annuity all around us. The monthly mortgage payments we make, the car loan or student loan that we pay off are all annuities. Annuities […]
Why Should Central Banks Be Independent?
Last month Donald Trump fueled a debate when he called the Fed “crazy.” Political accusations started flying all across the media. However, it raised a very important point. The world realized that Donald Trump is not in control of the Federal Reserve which is the central bank of the United States. To the financially savvy, […]
What is Venture Leasing? – Advantages and Disadvantages
In the previous few articles, we have already learned about how venture capital and venture debt work. We now also know the pros and cons of venture debt. However, there is another form of debt called venture leasing which is commonly used by investors in the marketplace. In this article, we will have a closer […]
Heuristics and their role in Finance
Traditional financial theories assume that finance is a scientific field. This means that just like in a scientific problem, a perfect solution exists even for financial problems as well. According to them, investors have the necessary resources and are capable of finding a solution to every problem in the financial domain. In reality, this is […]
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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