Financial ratio analysis is useless without comparisons. In doing industry analysis, most businesses use benchmark companies. Benchmark companies are those considered most accurate and most important. They’re used for comparison regarding industry average ratios. Companies even benchmark different divisions of their company against the same division of other benchmark companies. There are other financial analysis techniques besides ratio analysis to determine the financial health of a company. One example is a common-size financial statement analysis. These techniques fill in the gaps left by the limitations of ratio analysis, which are discussed below. However, if you use average ratios instead of the ratios of high-performance firms in your industry, you’re limiting your business. Reported values on balance sheets are often different from “real” values. Inflation affects inventory values and depreciation, as well as profits. If you try to compare balance sheet information from two different time periods and inflation has played a role, there may be distortion in your ratios. For example, the company may perform some transactions at the end of its fiscal year. It will impact its financial statements making them look better, but is then taken care of as soon as the new fiscal year starts. That is the simplest form of window dressing. When ratio analysis is used with knowledge and not mechanically (just cranking out the numbers), it can be a very valuable tool for financial analysis for the business owner. Its limitations have to be kept in mind, but they should be more or less intuitive to a savvy business owner.
