Profitability ratios analysis is a good way for measuring the performance of a company. It is the reason how businesses know if their capital allocation is right. Of course every positive has its negatives. Let us focus on its limitations in this post.
The main limitation of profitability ratios is that they are focused on the business performance generally in terms of income and expenses for a specific period of time. It disregards the financial strength of the business and the overall long-term outlook.
This means using other ratios along profitability ratios is important when analysing a company.
Quick Recap: What is profitability ratios?
Profitability ratios are calculations used by investors or loan providers to evaluate the business ability to generate profit in relation to their total revenue, operating capital, shareholder’s equity in a given period of time.
5 Limitations of Profitability Ratios
Measures Limited Time Frame
Businesses are always looking for new opportunities to re-invest their profits into as a way of growing their size. Re-investing the money in a new product or a business line is usually a long-term decision that require time to reflect on the business performance.
For instance, if a company launches a new product this given year and investors planned to calculate their return on equity (ROE) which is the (net income/shareholders equity) basically how much the business made profit out of its investors money. The ratio by itself may not provide fair representation because the business did not have chance to generate income from their new product of the year at the same time the equity invested have increased making the performance look weaker.
Another issue with profitability ratios is that they overlook the risks a business requires to generate profit by only focusing on the profit ratios which measures financial performance.
When external issues affect the business, the profitability ratio does not consider it. It is tough to recognise if a company is financially healthy or weak based on the profitability ratios only. External market factors such as an economical or environmental can result to influence lower profitability ratio for the coming years of the business.
The company profits records are done by the management, which leaves a lot of room for personalisation, and therefore, can be a tool for manipulation in a company. Managers, accountants, and analysts can make subjective decisions altering the real figures.
For example these manipulation could be done through false representation of assets valuation, depreciation and other expenses to reduce taxes or meet financing criteria.
Can’t Estimate the Future
Just like many other ratios, profitability ratios is an indicator on the present performance and not the future. Future predictions are solely based on the analyst research and findings.
As a note there are techniques including historical or cross sectors analysis. Looking at a sustainable high profitability ratio throughout the years while outperforming peer competitors are still sign of a healthy financial performance.
Challenging to Compare Companies from Different Jurisdictions
Another point to keep in mind is there are different methods of presenting financials and profits. These different policies governing businesses and accounting reporting methods can make it is tough to rely upon profitability ratio as a standard measure of profit.
Therefore, you may have to end up in normalising the figures for example when comparing two companies you may want to have a look at the ratios without the deduction of taxes or even bank interest just to measure the actual business performance.
Just remember at the end of the day these companies will have to pay their taxes and pay up their loans, unless there is a plan of refinancing or shifting to a different jurisdiction?
In conclusion, the profitability ratio is an essential way to have an idea of the business performance which allow us to support our estimated future profits projections in an investment.
Does the above limitations means we should not use them? Not at all! In fact if you dig deep in everything related to measuring companies performance and financial strength, they are always just indicators at the end of the day. Otherwise if they weren’t everyone would be a millionaire.
- 6 Key Objectives of Ratio Analysis
- 5 Key Limitations of the Balance Sheet
- Common Components of Income Statements Explained
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