Limitations Of Financial Ratios
While you are observing financial ratios in your exploration, or fundamental analysis of a security to reach a decision to buy or reject, keep in mind the potential for these limitations of financial ratios.
Limitations of Financial Ratios
Financial ratios provide valuable insight into a company’s performance, efficiency and future growth prospects. However, limitations of financial ratios can exist when analyzing a stock, you must keep certain things in mind before interpreting these ratios. These ratios cannot be interpreted in isolation. Alternatively they should be compared with industry averages and ratios of competitors in the industry. For example, a net profit margin of 10% may sound low, but it may be considered normal if the company is operating in the infrastructure industry. Similarly, ratios vary across industries. While a net profit margin of 12% may be outstanding for one type of industry, it may be considered as mediocre to poor for another.
Trend analysis of ratios can provide better insight into a company’s performance. However, it is important to be sure that the assumptions applied in calculating the ratios are constant throughout.