Top 5 do’s and don’ts of using financial ratios
Top 5 do’s
1. Do: use the right benchmarks
A ratio is meaningless and potentially misleading on its own. To interpret a ratio properly it is essential to use an appropriate benchmark.
Suitable benchmarks can be from internal or external sources. Internally: historic data or another product, service, customer or geographical territory make the best benchmarks. Externally: competitor information (if obtainable), industry data, external analyst reports and government statistics can be useful.
Be careful when comparing to the industry norm. This will be an average and include some extreme top performers and extreme poor performers which may distort the average. It is better to compare against a pre-selection of known good performers which provide the best comparison against your business.
At the same time it is important to remember that no two businesses are the same even if they are direct competitors in the same industry. They could be financed differently and have different tax rates, for example.
2. Do: use an appropriate number of ratios
There is a common desire for businesses to focus on one key ratio. In this book we talk about one of the most popular sole measures, ‘return on equity’ (Chapters 5 and 12). However, by focusing on one ratio there is a danger of missing out the essential feedback provided by using a variety of ratios.
Whereas it is useful to have a ‘primary’ ratio, using a portfolio of supporting ‘secondary’ ratios provides a fuller picture of a business. Additionally, ‘secondary’ ratios can help to ‘read between the lines’ and make sure the whole organisation is performing optimally.
A useful analogy is a car dashboard where the speedometer is the primary focus (or key ratio). However, the fuel gauge, tachometer, odometer, oil temperature, oil pressure and engine warning lights provide other essential information which affects the performance of the car.
At the other end of the scale is the symptom of ‘analysis paralysis’ where businesses monitor so many ratios that it is difficult to ‘see the wood for the trees’, let alone spot the primary measure.
Returning to the dashboard analogy, many non-pilots would find it challenging to navigate an instrument panel within the cockpit of a modern aircraft.
3. Do: consider timing issues
The financial statements on which many ratios are based are produced at a point in time. The balance sheet (covered in Chapter 2) is a snapshot of the business on a particular day. The position may be different the day before or the day after.
Therefore, it is important to look at trends in ratios versus interpreting ratios at a single point in time.
Seasonality may impact certain businesses. For example a calendar retailer will have high inventory as they build up stocks towards the year-end and hopefully low inventory by the time it gets to February.
Ratios can be influenced by a one-off event. For example, sale of a large asset prior to a company’s year-end may boost its bank balance temporarily.
Similarly, there may be a lag in results. A company may have raised debt to fund a sound and profitable investment which will not payback for a number of years.
Additionally, consider the impact of inflation on a company’s results. Inflation will impact the analysis of a business’s historical results over time. Ratios which indicate improved performance may tell a different story after adjusting for inflation.
Inflation will also impact the analysis of businesses of different ages, who may have purchased similar assets at different times. These assets may be shown at completely different values in each business.
4. Do: check the source of your data
When calculating internal ratios it is important to check the reliability and strength of the business’s accounting systems. A small calculation error in one part of the system can be magnified when compounded throughout the whole system. Additionally, when source data are contained in spreadsheets there can be an increased risk of errors.
If calculating ratios on external businesses, check if their accounts have been audited and if they have a clean audit report. Review their accounting policies, such as depreciation which will impact on ratios. Similarly look for changes in accounting policy which will impact the comparison of ratios across years. Be aware that financial statements can include assumptions, judgements and estimations. In addition, changes in accounting standards may impact on comparisons across financial years.
Financial statements are based on book (or historical) values, which may not reflect current reality. This is especially an issue for asset-based ratios. For example, the age of assets, their last revaluation date or if they have been revalued at all, should be considered.
Unethical companies can potentially take advantage of timing issues in what is referred to as ‘window dressing’, in order to create a desired ratio or even trend. These companies may be tempted to massage figures around their year-end when accounts are produced. For example, by delaying payments to suppliers at the year-end will increase both year-end cash and accounts payable balances.
5. Do: think twice
Top 5 don’ts
1. Don’t: rely on the past to predict the future
It is widely understood that past performance may not be an indicator of future performance.
The financial statements on which ratios are based are a reflection of the past as opposed to the present or even future situation. Therefore, ratios may be based on data which is out of date and not relevant to the future.
2. Don’t: rely on a rule of thumb
A good ratio for one business could be a poor ratio for another. A wide diversity of conditions exist in different types of business.
For example (as covered in Chapter 8), some businesses are able to exist comfortably with liquidity ratios that would spell disaster for others. Some businesses have to carry large stocks, have long production cycles and give long credit. Other businesses carry almost no stock and receive more credit than they give.
Strong liquidity in a high growth company could be interpreted as a positive sign. It could also be interpreted as a sign that the company is past the growth phase and this should be reflected in its valuation.
A high asset turnover ratio (covered in Chapter 6) may indicate efficient use of assets or may be indicative of an under-capitalised business which cannot afford to replace its assets.
Financial ratios are useful for analysing a business over time, for example, spotting a fall in profit margin. However, they can be less useful when comparing one business with another, despite their popularity. Differences in accounting policies and practice, for example depreciation rates, or companies that buy versus those that lease equipment, will make it more challenging to compare one business with another.
3. Don’t: expect ratios to tell you why something has happened
Ratios are a useful indicator of business performance. However, they indicate what has happened but not why it has happened. Although ratios can identify changes, there is no indication of the cause of these changes. Correlation does not imply causality.
Further analysis is therefore required in order to determine the cause of a trend. For example, an increase in accounts receivable days (see Chapter 8 on short-term liquidity) could be caused by an increase in sales, a change in credit policy, employee inexperience or potential customer dissatisfaction. It is not possible to reverse a trend until its cause is understood. Only then can the appropriate action be taken.
4. Don’t: just use financial ratios
Financial ratios and the financial accounts on which they are based are only part of the story. They cannot give a full picture of a whole business and its performance.
Non-financial ratios, often referred to as ‘key performance indicators’, are just as if not more important than financial ratios. They help to give a fuller understanding of the whole business. Customer satisfaction, internal processes, product/service quality, employee morale are all important performance measures which should be balanced against financial ratios.
Financial ratios are a great starting point for analysing business performance. However, further, wider and more balanced analysis is required to make informed decisions.
5. Don’t: use ratios to replace good management
Ratios should be seen as the starting point for further in-depth analysis. They are a great top-down tool and can be used to facilitate management-by-exception, however, they are just the start of the process.