What Financial Ratios Don’t Tell Investors?

Shareholders analyze the financial statements to have information about the earnings of the firm. Financial ratios tell a lot of thing about a company. Like:

  • It’s Profitability
  • Operational Efficiency
  • Solvency Probability
  • Overall Financial Strength or Weaknesses
  • Assess Management
  • Debt Management and so on

Financial ratios are being closely watched by not only shareholders but also the short and long-term creditors, institutional lenders, bondholders, government, managers, financial institutions, competitors and so on.

Different groups of stakeholders are concerned about different pieces of information on financial ratios.

Management is more concerned about the overall financial strength and weaknesses of the firm.

Shareholders are more concerned about the earnings of the firm. They are interested to know how earnings per share, dividend per share, rate of return on equity has been growing over the years.

Creditors and lenders are more concerned about the debt payment capacity of a firm.

Bondholders are more concerned about the fixed charge payment capacity of a firm.

Limitations of Financial Ratios

Financial ratios do not indicate the future. As they are calculated on the basis of historical accounting information, they simply suggest what happened in the past rather than what is going to happen in the future.

All financial ratios require a base for comparison to derive meaningful conclusion about firm’s financial performance. For example, a firm may have return on assets of 10 percent. It has to be compared with the ratio of similar firm or the ratio of industry averages to conclude on the profitability performance of the firm.

Therefore, it suffers from difference in interpretation. Different person may interpret the same ratios in different way.

Also, the financial ratios indicate quantitative factors of the company but not the qualitative factors, which are of major importance.

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