Dear Professor Cram:
Can you explain to me the concept of ratio analysis and the limitations of ratio analysis? Thanks!
Ken S., Hong Kong
Thanks for your question, Ken. In Finance, ratio analysis is generally used to compare the performance or position of a single company with other companies or with an industry.
There are several groups of ratios that each serve different purposes:
- Liquidity Ratios provide measures of how easily a firm can meet its obligations.
- Profitability Ratios indicate the earnings and profitability potential of a company.
- Asset Management Ratios measure how efficiently a company can turn its assets into sales.
- Debt Management Ratios indicate how leveraged a company is in terms of debt, and how well it can handle that debt with its assets and operating income.
- Dividend/Market Value Ratios measure how well a company uses its assets to generate earnings for its investors.
Ratios can provide meaningful comparisons of companies in similar industries or of a company in a single industry. As such, financial ratios should be evaluated in comparison to other companies in the same industry. For example, a dividend ratio of 5.2 means nothing by itself, and means very different things if the industry average is 22.5 as opposed to 1.5. For businesses that have operations in more than one industry, ratio analysis is less meaningful.
Also, keep in mind that ratio analysis does not tell the entire story. There may be good business reasons to support management's decision to reduce or increase liquidity or fixed assets in a different manner than the rest of the industry. Having a single ratio out of line with an industry, therefore, does not necessarily mean there is a problem.
Here is an overview on Ratio Analysis.