I am a big fan of financial ratio analysis for small businesses. I don’t have to inspire large companies to perform ratio analysis, because it is the daily bread of their Controllers and CFOs, but many small business owners have not yet gained an appreciation of just how valuable financial ratios are.

But as much as financial ratio analysis can help, it has its limitations, so let’s go into those limitations in more detail now.

Financial ratio analysis can be only as good as the financial data it is based on

Financial ratios are incredible. They reduce a complex set of numbers and relationships to a simple, 1 or 2 digit number which tells you volumes! But beware… What if those complex, underlying financial data are not reliable? A change by 1 or 2 percentage points in a ratio can drive many critical decisions – staff changes are decided on, products may be discontinued, sales price increases recommended, etc. I’m sure that the importance of reliable accounting information is now evident.

In many small businesses reconciled trial balance (yes, not only reconciled bank accounts!) and monthly, reviewed financial statements are simply not the norm. Many small businesses do not have adequate accounting systems nor do they all have competent accounting personnel who could be producing reliable monthly financial reports.

Calculating financial ratios with inaccurate financial data can be very dangerous. So, before any financial analysis is even attempted, the accounting records must be brought up to par.

Financial ratio comparisons can be meaningful only, if data is truly comparable

Bottom line is that it is very hard to compare different firms, even in the same industry. They employ different depreciation methods, use different inventory valuation methods, have different policies regarding capitalization of certain expenditures. All this makes it very hard to arrive at financial statements which can be compared meaningfully.

Even comparisons of different periods within the same company can get tricky. If there was no consistency in how transactions were posted – perhaps due to turnover or lack of knowledge on the part of the bookkeeper – comparisons will be less valuable until that situation is corrected. This brings us back to our first point – accounting records need to be not only accurate but also consistent.

Financial ratio analysis reflects only financial information

Obviously, financial ratios will reflect only what is based on the financial information. And as valuable as that can be, it does not capture many elements which can have decisive influence on the business and yet cannot be quantified or expressed in accounting terms.

During my stay as a part-time controller at an insurance firm which has just been acquired by an international player, the president was given a certain ratio as a target for his accounting department salary costs. Based on this ratio, he couldn’t increase accounting personnel even by one person. On the contrary, to meet the target, he had to reduce the staff.

But that didn’t consider the particular predicament this company was in. Due to historical reasons, the accounting 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 and to evaluate who should be let go and who should stay. This would take time, but would result in a much stronger department long-term. The target ratio wouldn’t allow for that. The savings had to be realized right away. Intelligent leadership will use ratios in proper context and in conjunction with other, just as important factors, and make the right business decisions based on the whole picture.

Other factors not contained in the financial statements can be technological developments, competitor’s actions, government actions, etc. All factors which might have an impact on the business have to be taken into consideration when making important decisions, not only financial ratios.

Still, financial ratio analysis is a fundamental component of those decisions and I would venture to say that a company, no matter how small, which doesn’t avail itself of this information is placing itself at a disadvantage.