The Financial Statement Analysis ratios are calculated from company's balance sheet and income statement and are used to evaluate the performance of the company in a particular reporting period.
Such ratios can be compared to the previous years in order to assess trends or between the comparable companies across the industry in order to get the relative performance estimate. It is highly important that every ratio should have a reference point - the industry (sector) average or median. The ratio analysis works better if comparing ratios not with the entire set of companies within a particular industry, but with a chosen subset of companies that share certain features, produce the same (or similar) product, and have identical macroeconomic and legislative factors affecting them. For the investigation of companies, operating in multiple industries it can be helpful to run a cross-sectional analysis to identify a group of firms, involved in the same mix of industries. In some cases a comparison to the economy averages can be meaningful, especially in booming or contracting economies. Thus, stable margins may be a good indicator during the recession, while the industry and economy averages are declin ing
. It is also important to note that usually conclusions can not be made from reviewing one set of ratios. That creates a necessity of a complex analysis of one set of ratios against another. The identification of the target ratio for the comparison may require a substantial amount of work and a good judgment in order to evaluate a range of possible and acceptable values.
Despite the obvious simplicity, such ratios have certain limitations that often make them most useful at identifying questions to be answered rather than giving answers to them. There are multiple factors affecting and limiting Financial Statement Analysis ratios, in particular the actual comparability of the firms and different accounting policies used by them are among the most important ones.
The issue of comparability may become one the critical aspects to pay attention to while performing the analysis. Various macroeconomic or legislative factors may apply to the companies in the same industry but in different countries that sometimes makes a direct comparison inappropriate. Comparisons with other companies may become even more difficult because of different accounting policies, especially outside the US. Thus different accounting methods may result in significantly different ratio values that require normalization by the analyst.
Seasonality may also affect the ratios if the business is a subject to seasonal fluctuations in demand, thus year-end values may not be enough representative and should also be normalized.
Most of the ratios are preferred to be within the industry averages or economy norms. For example, all turnover ratios belong to this category. However, for some ratios the extreme deviations from the industry averages may mean that the company is highly attractive for the investors. This is usually true for all ratios dealing with income or cash flows (i.e. ROA, ROE, ROIC etc).