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Value of Financial Ratios
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Financial ratios should always be used with caution. Ratios frequently give an indication of the symptoms of a problem. Further investigation or analysis is needed to identify the cause of the problem.
It is also important to compare financial ratios from year to year. By doing that we can see if the ratios are improving or not.
Ratios only have meaning if they can be compared with norm. For example, is a debt ratio of 60% good or bad? If we know that companies like the one being analysed have an average debt ratio of 40% and we know that the lower the better, we can accept that 60% is not good.
Three norms are used for comparison:
- Cross sectional analysis: that is comparing the company being analysed to companies of similar size and with similar markets (products).
- Time series analysis: that is comparing the company being analysed with its own performance over time.
- Rules of thumb: certain values, found to be consistent over time, have developed into norms themselves.