To help identify potentially profitable investments, an investor must understand the financial position of a company or firm. When making lending and underwriting decision, a financial institution must have an understanding of the company's financial statements. Ratio analysis allows for a basic analysis and summary of a company's financial strengths and a basic understanding of a firm's financial profile.
Advantage: Performance Over Time
Ratio analysis is a strong indicator of the financial performance of a company over time. An analyst can calculate the same ratio across different time periods to identify particular components of a company's financial performance that may be improving or declining. Ratio analysis uses relative percentages rather than dollar amounts, allowing for ease of comparison across periods. Ratio analysis may help distinguish between firms that may fail and firms that are profitable. Through the careful use of financial ratio analysis, an analyst may be able to detect financial troubles up to five years before a firm fails.
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Advantage: Performance Against Competitors
Ratio analysis can be used to assess the performance of a company against other competitors that operate within the same industry. Companies that operate in the same industry generally exhibit similar financial profiles. Thus, a calculated ratio that is significantly above or below the industry average may indicate a particularly strong or particularly weak performance by the company in certain areas.
Disadvantage: Narrow Focus
Ratio analysis may lead to a narrow focus on certain elements of a company's financial performance. It is important to consider all ratios in relation to one another. For example, one ratio may indicate low levels of liquidity while another ratio may indicate a high level of operating profitability. Financial ratios should be considered as a whole; in the event of seemingly contradictory information, a more thorough financial statement analysis may be warranted.
Disadvantage: Accounting Methodologies
Certain ratios may be adversely affected by a company's accounting methodologies. For example, accelerated depreciation may overstate the true depreciation cost to the company. Debt may be financed through various subsidiaries or off-balance sheet accounts. Thus, when reviewing the results of a financial ratio analysis, an analyst must be aware of the financial accounting methodologies employed by the company. These are often discussed in the notes to the financial statements.