The Uglier Side of Fracking
The press releases by the United States oil companies will have you believe that fracking is the best thing that has been discovered since “fire”! The newspapers are full of praise for the new technique and how it is likely to bring back the glorious days when America was self-reliant with regards to energy. However, […]
Uber’s New Businesses
Uber is already a well-known brand across the world. Technically, the company is still a startup. However, Uber has a valuation of close to $70 billion. Also, the company is planning for an aggressive IPO. It is estimated that Uber’s post IPO valuation will be close to $120 billion. This is phenomenal given the fact […]
How Business Cycles Affect Start-Up Companies
Start-up businesses are affected by a wide variety of factors. Macroeconomic factors such as business cycles affect start-up organizations as much as they affect any other businesses. In fact, since start-ups are in a nascent stage, they face a bigger impact from these business cycles. Start-ups that face recession or slowdown early after their inception […]
Understanding Investor Focus on Burn Rate
Burn rate is a metric that is specific to the start-up world. On the one hand, most of the financial world is obsessed with frugality but at the same time, investors in start-up companies often pressurize the management to spend as much money as possible within a short span of time. The excess of spending […]
What is a Start-up Accelerator?
The past decade has seen a rapid increase in the number of start-ups. There are more companies which start up every year now as compared to a decade earlier! As a result, there are numerous new kinds of players which have come into existence in the start-up universe. One such type of company is called […]
Ratio analysis, without a doubt, is amongst the most powerful tools of financial analysis. Any investor, who wants to be more efficient at their job, must devote more time towards understanding ratios and ratio analysis. However, this does not mean that it is free of limitations. Like all techniques, financial ratios have their limitations too. Understanding the limitations will help investors understand the possible shortcomings with ratios and avoid them. Here are the shortcomings:
The first and foremost threat to ratio analysis is deliberate misleading statements issued by the management. The management of most companies is aware that investors look at certain numbers like sales, earnings, cash flow etc very seriously. Other numbers on the financial statements do not get such attention. They therefore manipulate the numbers within the legal framework to make important metrics look good. This is a common practice amongst publicly listed companies and is called “Window Dressing”. Investors need to be aware of such window dressing and must be careful in calculating and interpreting ratios based on these numbers.
Comparison is the crux of ratio analysis. Once ratios have been calculated, they need to be compared with other companies or over time. However, many times companies have accounting policies that do not match with each other. This makes it impossible to have any meaningful ratio analysis. Regulators all over the world are striving to make financial statements standardized. However in many cases, companies can still choose accounting policies which will make their statements incomparable.
Comparison over time is another important technique used in ratio analysis. It is called horizontal analysis. However, many times comparison over time is meaningless because of inflation. Two companies may be using the same machine with the same efficiency but one will have a better ratio because it bought the machine earlier at a low price. Also, since the machine was purchased earlier, it may be closer to impairment. But the ratio does not reflect this.
Financial ratios are established “thumb of rules” about the way a business should operate. However some of these rules of thumb have become obsolete. Therefore when companies come with a new kind of business model, ratios show that the company is not a good investment. In reality the company is just “unconventional”. Many may even call these companies innovative. Ratio analysis of such companies does not provide meaningful information. Investors must look further to make their decisions.
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