Analysts like to use financial margins and ratios to tell the story of a business. But it’s easy to overlook some of their limitations and so get a distorted view.
Don’t confuse ratios and margins with actual values
Because we spend so much time working with ratios and margins it’s easy to forget what the actual values are. For example, you might feel that a business with a profit margin of 5% is not very profitable. But, if revenues are US$200m, then that 5% translates into a profit for the year of US$10m which is not a small amount.
Ratios and margins are not predictors of the future
The ratios and margins that are used in financial analysis are generally historical in that they are based on financial statements that are, at best, a few months old. Remember that the financial information is the result of a set of specific circumstances in the business’ operating environments and there’s no guarantee that those circumstances will still be the same in the current or next financial period.
We use the ratios as a basis from which to project forward what the business’ performance and financial position might be like in the future based on our understanding of what the business environment may be like in the next several months and our understanding of what the business’ drivers are and the way they impact the financial results.
The most obvious forward-looking calculation that lenders can do is to add in the interest cost and approximate capital repayments on any new debt that the business may now be requesting (which is often the reason for conducting a financial analysis).
Limitations of Ratio Analysis
- Ratios may be based on stale financial information – financial statements may be several months old by the time they are received for analysis.
- Some of the figures contained in the balance sheet may, themselves, be historical in the sense that fixed assets are brought onto the balance sheet at their initial cost which could have been some years before. The true value of the assets may be different and this could mean that some of the ratios will not tell the true story.
- The ratios are based on balance sheet information which is representative of only one day in the accounting period. It is relatively easy to manipulate some of the figures in the balance sheet and so the analysis and interpretation of the information may not be a true reflection of the business’ real financial position.
What ratios measure
Ratios are used to give us an insight into the financial aspects of any business that interest us most;
- Operating performance; the ability of a business to generate revenue in excess of its expenses (i.e. make profits) by utilising the resources at its disposal.
- Operating efficiency; the ability of the business to manage its working capital effectively to ensure adequate cash flow.
- Debt service coverage; the ability of the business to make scheduled repayment of interest-bearing debt and to service interest expense.
- Liquidity; the ability of the business to meet its short-term commitments as they fall due (usually they are met from the short-term assets as they turn into cash).
- Capital structure; the mix of debt and equity funding that a business uses to finance its assets and the consequent risk profile.