ratio analysis

How accurate are the results of ratio analysis? Is seems as if a lot of items that businesses include on their financial statements are not what they seem. For example, companies include assets as marketable securities that, in truth, are not marketable at all.

Ratio analysis is only as good as the inputs that produce the ratios' outputs. To the extent that the measurements are flawed, inconsistent over time, or incomparable among firms, ratio results will provide little, if any, information. The analyst must standardize ratio inputs, so far as the financial data permit, in order to use ratios in financial analysis.

Generally accepted accounting principles and ethical disclosure practices are also important factors in using ratios. As your comment implies, reporting securities without an actual market in the financial statements overstates assets and would create a favorable bias in many ratios, such as the current ratio. The Financial Accounting Standards Board clarified its definition of fair (market) value in 2007. That financial statement closed many loopholes regarding market-based disclosures. That FASB ruling, as with all others, will only be effective if management conforms to the spirit of the standard and tries to report economic reality.

Peter M. Bergevin, PhD, Professor of Accounting, School of Business, University of Redlands, Redlands, CA