Advantages and Disadvantages of Financial Ratios
Financial ratios are numerical representations of a business's performance. You can calculate such ratios by dividing one figure from the balance sheet, income statement or cash flow statement by another. For example, the current ratio equals short-term assets divided by short-term liabilities. Financial ratios are an indispensable tool in understanding the performance of your own business or any other business you wish to analyze. However, it is important to grasp their shortcomings as well.
Financial ratios simplify complex sets of data and save you time as well as effort. The debt-to-asset ratio takes less than a minute to calculate by dividing total debt by total assets, both of which are clearly spelled out in the balance sheet. The resulting number provides an idea about the strategy as well as viability of the business.
A high ratio indicates that the firm chose to rely heavily on borrowed funds and may have a hard time repaying the debt when payment obligations come due. Without using ratios, such information would be very hard to gather and require many hours to go through annual reports, news reports and so on.
Ratios make it very easy to compare firms against each other. If you are evaluating two businesses to hire as subcontractors, their respective debt-to-asset ratios will give you an idea about which of these two companies is the more stable choice. The company with a higher debt-to-asset ratio could be more likely to go out of business as a result of defaulting on interest and principal repayments.
However, if your primary objective is investing in a business, and you are seeking high returns, the company with the higher ratio may be a better bet. Firms that borrow heavily are high-risk, high-return investments and tend to do either very well or fail spectacularly.
The biggest strength of ratios, namely their simplicity, is also their greatest weakness. By reducing a complex set of data to a single figure, ratios can sometimes miss the bigger picture. The firm with the higher debt-to-asset ratio may actually be a safer option due to its unique circumstances, for example.
A construction firm might have borrowed heavily to build an enormous bridge, which has just been completed. The company may soon collect a huge payment that will more than make up for all of its outstanding debt. Ratios do not communicate such information and can sometimes give the wrong impression.
Financial ratios are based on the firm's three major financial statements: the balance sheet, the income statement and the cash flow statement. The figures in these statements reflect a snapshot of the past, as opposed to a depiction of the future or even the present conditions. Since financial statements take considerable effort to prepare and review, they are always at least somewhat outdated. Especially for firms that publish key data only once at the beginning of each year, the ratios may be based on data that is no longer relevant.