I’m a big fan of ratio analysis for small business owners. I don’t have to inspire CFOs and Controllers of large companies to do ratio analysis, because it’s their bread and butter, but I find that many small business owners still haven’t appreciated what financial ratios can do for them.

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

Ratio analysis can only be as good as the underlying data.

The proportions are absolutely wonderful. They reduce a complex set of numbers and relationships to a simple 1 or 2 digit number that tells you the volumes! But beware… What if that complex underlying data isn’t accurate? Many important decisions are made because a proportion has changed by 1 or 2 percentage points. Given that, your accountant had better make sure the calculations can be trusted.

In the small business environment, things like the reconciled trial balance (yes, not just bank accounts!) and monthly reviewed financial statements cannot be taken for granted. Many small businesses do not have proper accounting systems in place or competent accounting staff to ensure that monthly financial results are not only available, but accurate.

Calculating any ratio based on questionable data and an unreconciled set of books can be very dangerous. Therefore, before any analysis is attempted, the accounting records must be up to par.

Comparisons of proportions can only be meaningful if the data is truly comparable.

It is challenging to achieve comparability between different companies, even in the same industry. Different depreciation methods, different inventory valuation methods used, different policies regarding the capitalization of certain expenses make it very difficult to arrive at financial statements that can be meaningfully compared.

But even comparisons of different periods within the same company can be tricky. I have seen many small businesses with high bookkeeping/accounting job turnover and my general ledger review often revealed that there was no consistency in how many transactions were being accounted for by those different people. This would make the comparisons less valuable than they might otherwise be. This brings us back to our first point: accounting records must be not only accurate but also consistent.

Ratio analysis reflects only what is in the financial statements

Obviously, the financial ratios will reflect only what is contained in the company’s financial reports. And as valuable as it may be, it doesn’t capture many factors that can have a profound impact on the business and yet cannot be quantified or expressed in accounting terms.

I remember acting as a part-time controller for an insurance company that was just bought by an international player. The president was given a certain target ratio for the salary costs of his accounting department. Based on this ratio, he was unable to add a single person to his accounting staff. On the contrary, in order to reach the goal, he would have to let some people go first.

But that didn’t take into account the particular situation this company found itself in. Due to historical reasons, the staff was very low qualified, the systems were old, and the only way out was to bring in a strong full-time controller or CFO to reorganize the department. The target relationship would not allow that. But it was the best he could do under the circumstances. Smart leadership will recognize such scaling limitations and make the right business decisions anyway.

Other factors not contained in the financial statements may be technological developments, competitor actions, government actions, etc. All items with potential business impact must be evaluated when making important decisions, not just financial ratios.

Still, financial ratio analysis is a key component of those decisions, and I would venture to say that a company that does not take advantage of this information is at a disadvantage.