Financial Ratios: Uses and Limitations

Financial Ratio Uses

• Valuing a company’s stock.
• Determining a company’s systemic risk (beta risk) exposure.
• Creating a company’s credit rating.
• Predict a company’s likelihood of financial distress (i.e. bankruptcy).
• Preparing pro forma financial statements that provide estimates of financial statements for future periods.

Financial Ratio Analysis Limitations

While financial ratios can provide valuable insights to analysts, they cannot be considered all knowing.  Ratio analysis can be limited by:

• Application of different accounting methods by firms which are being compared.
• Multiple firm operations; when a company has multiple business units, it can be difficult to determine the appropriate industry norms for ratio analysis.
• Need to consider all ratio categories when analyzing a company, as one category of ratios may not tell the complete story.
• Analyst judgment; ultimately the analyst must decide what an appropriate ratio range is for a given firm or industry.