Pros & Cons of Financial Ratios
Financial ratios, mathematical relations between financial numbers, are commonly used by potential investors and creditors to determine the financial health of a company. While these figures can be quite useful to a skilled financial statement analyst, there are both pros and cons to ratio analysis. Understanding where ratios shine and when they aren't as helpful can help you use this technique to check the health of your small business.
One of the most useful qualities of financial ratios is their ability to help uncover financial conditions that are other wise difficult to detect. For example, when comparing two companies, it can be difficult to determine which company is more likely to be able to pay creditors as bills come due. This is especially true if the companies are different sizes. However, an investor can calculate a liquidity or solvency ratio for each company and have a direct way to compare the two options.
Unlike most accounting information, financial ratios are often oriented toward the future. Most ratio analysis is done by potential lenders and investors. As such, many financial ratios are geared toward helping these parties determine the health of a company and the likelihood of recouping an investment or return of the principal of a loan. However, this doesn't mean that the small-business owner can't benefit from the techniques. Because financial ratios are future-focused and standardized, the small-business owner can know what the lender is going to be looking for in advance. This allows the owner to prepare an explanation for ratios that may not accurately describe the business and to help focus attention on the ratios that are the most flattering of the company.
One of the disadvantages of financial ratios is that most ratios need some kind of a basis for comparison. This can be difficult for small-business owners. Most small companies do not make financial information available to the public. As such, a small-business owner can only really compare performance to that of public companies. Often, this is a poor basis for comparison. While larger companies often have greater resources, these companies also have different costs, incentives and business strategies. This problem is partially alleviated by using past performance for comparison, but this can only really tell you about whether you are getting better or worse, not whether or not you are doing well in comparison with your peers.
As financial ratios are calculated from financial statements, these ratios change as accounting methods and rules change. This can make comparison difficult. For example, as technology has increased rapidly, companies have found that computers can quickly become obsolete and are, generally, much less expensive than in the past. As a consequence, many companies have moved away from capitalization of standard computer equipment. Instead, these companies expense computers are they are purchased. In this case, the difference in accounting method increases assets in one case and increases expenses in the other case. Comparisons between companies practicing these different methods can be difficult. In addition, comparisons within a company before and after the change in accounting policy have the same difficulty.