Limitations of Financial Ratio diagnosis

I am a big fan of ratio pathology for small company owners. I don't have to inspire large company Cfos and Controllers to accomplish ratio analysis, because it is their daily bread, but I find that many small company owners have not yet gained an appreciation of what financial ratios can do for them.

But as much as ratio pathology can help you, it can also mislead, so I opinion it would be good to delve into the limitations of financial ratio pathology today.

Financial Power Of Attorney

Ratio pathology can be only as good as the fundamental data
Ratios are legitimately wonderful. They boil down a involved set of numbers and relationships to a simple, 1 or 2 digit estimate which tells you volumes! But beware... What if those complex, fundamental data are not accurate? Many foremost decisions are made because a ratio has changed by 1 or 2 division points. Given that, your accountant great make legitimately sure that the calculations can be relied upon.

Limitations of Financial Ratio diagnosis

In the small company environment things like reconciled trial balance (yes, not only the bank accounts!) and monthly, reviewed financial statements cannot be taken for granted. Many small businesses do not have sufficient accounting systems in place nor do they all have competent accounting personnel development sure the monthly financial results are not only available, but legitimately accurate.

Calculating any ratios based on questionable data and an unreconciled set of books can be very dangerous. So, before any pathology is even attempted, the accounting records must be brought up to par.

Ratio comparisons can be meaningful only, if data is truly comparable
It's a challenge to accomplish comparability among distinct firms, even in the same industry. distinct depreciation methods, distinct inventory valuation methods used, distinct procedure regarding capitalization of clear expenditures make it very hard to arrive at financial statements which can be compared meaningfully.

But even comparisons of distinct periods within the same company can get tricky. I have seen many small businesses with a high turnover of the bookkeeping/accounting position and my chronicle of the normal ledger revealed often that there was no consistency in the way many transactions were posted by those distinct people. This would make comparisons less important than they could otherwise be. This brings us back to our first point - accounting records need to be not only strict but also consistent.

Ratio pathology reflects only what is in the financial statements
Obviously, financial ratios will reflect only what is contained in the financial reports of the company. And as important as that can be, it does not capture many factors which can have a profound impact on the company and yet cannot be quantified or expressed in accounting terms.

I remember acting as a part-time controller for an guarnatee firm which has just been purchased by an international player. The President was given a clear ratio as a target for his accounting department salary costs. Based on this ratio, he couldn't add a particular someone to his accounting staff. On the contrary, to meet the target, he would have to let some citizen go first.

But that didn't take into observation the particular situation this company was in. Due to historical reasons, the staff had very low qualifications, systems were old and the only way out was to bring a strong full-time controller or Cfo to reorganize the department. The target ratio wouldn't allow for that. But it was the best thing to do in those circumstances. Thoughprovoking leadership will identify such limitations of ratios and make the right company decisions anyway.

Other factors not contained in the financial statements can be technological developments, competitor's actions, government actions, etc. All elements with potential impact on the company need to be evaluated when development foremost decisions, not only financial ratios.

Still, financial ratio pathology is a key component of those decisions and I would speculation to say that a company which doesn't avail itself of this information is at a disadvantage.

Limitations of Financial Ratio diagnosisWhy Real Conservatives Are Against the War on Terror, Part 1 [CPAC 2010] Tube. Duration : 46.17 Mins.

Is America's current War on Terror essential to keeping our nation safe? Or is it yet another vehicle for the federal government to increase its power over our lives and take away our liberties? Is the War on Terror actually weakening our national defense and increasing opposition overseas? The panel, co-sponsored by The Future of Freedom Foundation, Ladies of Liberty Alliance and Campaign for Liberty, included: - Karen Kwiatkowski — retired US Air Force Lieutenant Colonel - Jacob Hornberger — founder and president of The Future of Freedom Foundation - Philip M. Giraldi — former CIA counter-terrorism specialist and military intelligence officer, current Francis Walsingham Fellow at The American Conservative Defense Alliance - Bruce Fein — former associate deputy attorney general in the Reagan administration Related links: www.fff.org http www.campaignforliberty.com

Keywords: future, of, freedom, foundation, ladied, liberty, alliance, karen, kwiatkowski, jacob, hornberger, philip, m., giraldi, bruce, fein, libertarianism, libertarian, anti-war, classical, liberalism, conservatism, neo, conservatives, republicans, democrats, iraq, war, on, terrorism, terror, terrorist, warfare, welfare, police, state, united, states, government, totalitarianism, tyranny, statism, militarism, george, bush, barack, obama, homeland, security, imperialism, globalism, occupation, interventionism, american, foreign, policy, aggression, conflict