What is Internal Rate of Return (IRR) ?
The Internal Rate of Return (IRR) is another very important metric that can be used to determine whether or not a company must invest its resources in a project. If the company does decide to invest its resources in all the projects then the IRR can help us understand what should be the priority of […]
Junk Bonds in Investment Banking
Investment bankers help their clients raise money by selling equity as well as bond securities on the securities markets. Investors know that equity securities are risky by their very design. However, when investors think about debt, they often think about secure investments, which are almost certain to pay a fixed rate of return. Debt is […]
What is Perpetuity? – Make Smarter Investment Decisions
Perpetuity is a very important concept in corporate finance. The concept of perpetuity makes it possible to value stocks, real estate and many other investment opportunities. The valuation of perpetuities is theoretically very simple. The concept of perpetuity as well as the formula required for its calculation has been explained in this article: Stream of […]
Issues With Merchandising
In the previous article, we have already studied what merchandising is. We now know why it is an important source of revenue for the sports team. We also know how the business of merchandising is conducted and what are the benefits of the same. However, it needs to be understood that there are a lot […]
The Role of the Finance Function in Organizational Processes
The Finance Function and the Project Office Contemporary organizations need to practice cost control if they are to survive the recessionary times. Given the fact that many top tier companies are currently mired in low growth and less activity situations, it is imperative that they control their costs as much as possible. This can happen […]
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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