Financial Modeling Guide

While financial ratio analysis can provide us with important insight into a company’s performance, a good financial analyst will be aware that there are some important limitations that should be noted when using financial ratios as an analytical tool in financial modeling.

Limitations of Financial Ratio Analysis

• Ratio analysis is a retrospective, not prospective examination.
• Ratio analysis is based on accounting not economic data.
• Ratios don’t capture significant off-balance sheet items.
• Basic ratios can be manipulated through acceptable alterations of accounting policies (e.g., LIFO/FIFO).
• Financial statement accounts reflect historical cost not necessarily current economic value.
• Cash flow measures have been proven to be more closely correlated with stock price movement that income based measures.

The table illustrates how traditional accounting based profitability financial ratios often yield ambiguous results. 

Issues	ROA	ROE	ROI	ROCE	Profit Margin
Do not incorporate opportunity cost or risk	x	x	x	x	x
Often mislead managers to slash assets rather than invest	x	x	x	x
Ignore cost of capital investments required to generate earnings		x			x
Difficult to compare with other opportunities when used in isolation	x	x	x	x	x
May be affected by financing decisions (e.g., tax implications of interest on debt, dividend policy)		x	x	x

Be sure to also download this excellent financial ratio analysis template available in the Finance 3.0 forums, that allows you to calculate, analyze and compare a set of business & financial ratios to assess & measure the operating performance of your own business or businesses / stocks that you intend to invest in.

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