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Ratio Analysis Isn't Enough
5 reasons it falls short + what to do about it
Financial ratios provide a straightforward means to evaluate a company’s past and current performance. Their widespread use also allows owners to easily see how their business stacks up against key competitors and the industry overall.
Tactically speaking, ratio analysis not only helps SMBs to quickly identify sources of inefficiency within the company, but it also enables them to pinpoint unique areas of strength.
That said, simply measuring ratios is not enough to evaluate the financial success of your business.
There are 5 main reasons for this.
Reason #1: The Inflation Effect
Reason #2: The Seasonal Effect
Reason #3: The Creativity Effect
Reason #4: The Inconsistency Effect
Reason #5: The Context Effect
In this week’s post, I’ll be breaking down and explaining what to do about each. That way, you’ll arrive at accurate ratios that drive the right decisions.
So, let’s get into it.
The Inflation Effect
Historical data on its own doesn’t account for price increases across periods. This affects not only your pricing, but also your cost structure and business model.
For instance, revenue may grow over time due to inflation, but this is not an increase in real terms. Your best bet in this case is to adjust for inflation before engaging in any period-over-period comparisons.
The Seasonal Effect
Seasonality can have a massive impact on your business—from sales and inventory to cash flows.
And you need to be aware of the degree of seasonality in your business before engaging in ratio analysis.
This is because ratios must be compared on a like-to-like basis. Failure to do so leads to inaccurate comparisons at best and misguided decisions at worst.
To avoid this, track your A/R and A/P as a % of your revenue and expenses. Doing so will give you a better picture of where your business stands at different points throughout the year. As a bonus, it’ll improve your cash position.
The Creativity Effect
The creativity effect is a nice way of stating the fact that numbers can be adjusted to paint a rosier picture of the business.
This can come by classifying one-off inflows as recurring revenues or labeling recurring costs as one-time expenses. Incorrect inventory estimates are another common example of this phenomenon at work.
Since these adjusted figures can lead to gross miscalculations, be sure to start with a clean set of numbers. Work with your finance department until every discrepancy has been identified and addressed, paying special attention to one-off income or sales.
ERC tax credits over the previous few years are great examples of one-off inflows that need to be removed prior to comparison.
The Inconsistency Effect
The inconsistency effect occurs when numbers become incomparable due to accounting or policy changes—either internal or governmental.
Note that this can also be an issue if you’re comparing your performance to that of a competitor. Avoid making too many assumptions in this case as their policies (e.g., inventory valuation methods, accrual vs. cash accounting, etc.) could differ considerably from yours.
If your business is transitioning from cash to accrual accounting, special care needs to be taken to ensure that your historical data doesn’t become unusable. Making retroactive adjustments is key to ensuring consistency over time.
The Context Effect
You should always be able to articulate the context behind each ratio that you measure. In other words, you need to know why changes are happening, not just their magnitude and direction over time.
Doing so will allow you to understand better where growth is coming from and what changes need to be made.
For example, an e-commerce business should consider both unit and AOV growth over time. Considering both measures will determine whether growth is being driven by volume or pricing economics.
Additionally, an increased current ratio looks like great news. But is cash temporarily inflated? 60 Days Sales Outstanding is concerning, but the macroeconomic environment behind that number needs to be considered.
Putting It All Together
Here are your top takeaways from this week’s post.
Ratio analysis is useful for determining past and current performance, measuring competitive position, and identifying areas of strength and weakness in the business.
But the inflation effect, seasonal effect, creativity effect, inconsistency effect, and context effect, all cause simple ratio analysis to fall short.
The inflation effect occurs as a result of price increases over time. Adjust each period to reflect real dollars before engaging in any period-over-period comparisons.
The seasonal effect can lead to inaccurate comparisons across time. Be sure that you understand the degree of seasonality in your business and make appropriate adjustments.
Avoid painting an overly rosy picture of your business by classifying revenue, expenses, and inventories accurately. Then remove any one-time events that would distort period-over-period comparisons before making your calculations.
Measuring ratios over time is not enough. You need to be able to explain why changes are occurring in the business.
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‘Til Next Time,
Connor