The limitations of financial ratios
Applying mathematical ratios to the figures in a company's financial statement can help you build a picture of how a company works, as well as alerting you to potential trading and investing opportunities.
Companies do not exist in a vacuum, however, and a number of external elements will make certain ratios more or less useful depending on the economic climate, government actions and market sentiment.
Even within a company, there may be events – such as the appointment of a new CEO or the launch of a new product – that are difficult for investors to foresee. Things like this can blow out of the water any trading decisions you have made based on analysis of old financial statements.
It is important therefore that you apply financial ratios with caution, remaining aware of their limitations and of other factors that could override them.
No two companies are the same
No two companies are exactly alike, and that is especially so when they are operating in different industries.
As discussed in the previous lessons, capital-intensive companies like airplane manufacturers rely more heavily on debt, have less liquid assets and tend to grow more slowly than, for example, software companies.
These factors will affect how ratios such as debt to equity or return on capital should be interpreted when you are deciding whether to buy or sell their shares.
Companies that carry a lot of inventory, which they can in theory sell quickly for cash, (retailers, for example) similarly require a different approach when interpreting things like the current ratio than when you are looking at a construction company.
Companies also require a different approach depending on their size.
Small-cap companies often pay more for their debt than large-caps, and this will affect the way formulas like interest coverage ratios need to be interpreted. They also tend to have faster growth prospects, and this will change the way things like the discounted cash flow model are calculated.
A change in destiny
A company’s destiny can change with just one key event, making analysis of its historical performance virtually redundant.
When apple launched the iPod, for example, everything from its price to earnings ratio to the fair value that analysts assigned it changed dramatically.
A new CEO can also introduce dramatic changes at a company that will have been difficult for investors to factor in to their analysis ahead of the event.
New leadership at a company can trigger big restructurings, including whether it borrows more heavily or pays off debt and how it approaches other costs. Therefore, financial performance ratios in particular could undergo rapid change while other ratios such price to book may now become misleading.
Market sentiment and macro factors
Market sentiment can change very quickly and the risk appetite of other traders can have a big impact on the price of shares you have invested in, regardless of the fundamental factors you have studied when making your analysis.
Tolerance for risk can increase
There are times when investors have a stronger than usual appetite for risk – for example when an economy is expanding, interest rates are low and stock markets in general are climbing.
At these times they will be more prepared to take a gamble on companies that investors might normally ignore. This could include high-risk small-caps, or firms whose financial performance or health ratios are shaky.
This can quickly push up the share price of companies that based on your fundamental analysis you had decided to avoid investing in or, if you are a CFD trader, to short for a profit.
Risk appetite can decline
Conversely, if other traders become risk averse, a stock that you have analysed in detail and decided is fundamentally strong may be punished along with its peers as investors exit stock markets.
Economic cycles can change
Similarly, a change in the economic cycle, in taxation, in government legislation or even the weather can affect individual sectors disproportionately and drive share prices in directions that may seem irrational if you focus exclusively on companies' financial statements.
In this lesson you have learned that ...
- … there are limitations of financial ratio analysis' effectiveness.
- … companies do not exist in a vacuum – external elements like the economy, government action and market sentiment will affect their share price.
- … internal events like a new product or CEO will also affect the price of a share.
- … companies are all different and the way you interpret their ratios should reflect what sector they operate in and their size.
- … companies can change overnight – for example with a new leader – making analysis of their historical performance irrelevant.
- … market sentiment can affect the share price of the company you are trading, regardless of its fundamental strength or weakness.
- … so can a change in the economic cycle, in taxation, in government legislation or even the weather.