Limitations of Financial Ratios in Financial Modeling

Limitations of Financial Ratios in Financial Modeling

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  

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