| I am a big fan of ratio analysis for small business | | | | the same company can get tricky. I have seen |
| owners. I don't have to inspire large company | | | | many small businesses with a high turnover of the |
| CFOs and Controllers to perform ratio analysis, | | | | bookkeeping/accounting position and my review |
| because it is their daily bread, but I find that | | | | of the general ledger revealed often that there |
| many small business owners have not yet gained | | | | was no consistency in the way many transactions |
| an appreciation of what financial ratios can do for | | | | were posted by those different people. This |
| them. | | | | would make comparisons less valuable than they |
| But as much as ratio analysis can help you, it can | | | | could otherwise be. This brings us back to our |
| also mislead, so I thought it would be good to | | | | first point - accounting records need to be not |
| delve into the limitations of financial ratio analysis | | | | only accurate but also consistent. |
| today. | | | | Ratio analysis reflects only what is in the financial |
| Ratio analysis can be only as good as the | | | | statements |
| underlying data | | | | Obviously, financial ratios will reflect only what is |
| Ratios are absolutely wonderful. They boil down a | | | | contained in the financial reports of the company. |
| complex set of numbers and relationships to a | | | | And as valuable as that can be, it does not |
| simple, 1 or 2 digit number which tells you | | | | capture many factors which can have a profound |
| volumes! But beware... What if those complex, | | | | impact on the business and yet cannot be |
| underlying data are not accurate? Many important | | | | quantified or expressed in accounting terms. |
| decisions are made because a ratio has changed | | | | I remember acting as a part-time controller for an |
| by 1 or 2 percentage points. Given that, your | | | | insurance firm which has just been purchased by |
| accountant better make really sure that the | | | | an international player. The President was given a |
| calculations can be relied upon. | | | | certain ratio as a target for his accounting |
| In the small business environment things like | | | | department salary costs. Based on this ratio, he |
| reconciled trial balance (yes, not only the bank | | | | couldn't add a single person to his accounting staff. |
| accounts!) and monthly, reviewed financial | | | | On the contrary, to meet the target, he would |
| statements cannot be taken for granted. Many | | | | have to let some people go first. |
| small businesses do not have adequate accounting | | | | But that didn't take into consideration the |
| systems in place nor do they all have competent | | | | particular situation this company was in. Due to |
| accounting personnel making sure the monthly | | | | historical reasons, the staff had very low |
| financial results are not only available, but actually | | | | qualifications, systems were old and the only way |
| accurate. | | | | out was to bring a strong full-time controller or |
| Calculating any ratios based on questionable data | | | | CFO to reorganize the department. The target |
| and an unreconciled set of books can be very | | | | ratio wouldn't allow for that. But it was the best |
| dangerous. So, before any analysis is even | | | | thing to do in those circumstances. Intelligent |
| attempted, the accounting records must be | | | | leadership will recognize such limitations of ratios |
| brought up to par. | | | | and make the right business decisions anyway. |
| Ratio comparisons can be meaningful only, if data | | | | Other factors not contained in the financial |
| is truly comparable | | | | statements can be technological developments, |
| It's a challenge to achieve comparability among | | | | competitor's actions, government actions, etc. All |
| different firms, even in the same industry. | | | | elements with potential impact on the business |
| Different depreciation methods, different | | | | need to be evaluated when making important |
| inventory valuation methods used, different policy | | | | decisions, not only financial ratios. |
| regarding capitalization of certain expenditures | | | | Still, financial ratio analysis is a key component of |
| make it very hard to arrive at financial | | | | those decisions and I would venture to say that a |
| statements which can be compared meaningfully. | | | | company which doesn't avail itself of this |
| But even comparisons of different periods within | | | | information is at a disadvantage. |