20 Limitations of Ratio Analysis

The following limitations of ratio analysis must be taken into account :

1. Over-use of ratios as controls on managers could be dangerous; in the management might concentrate more or simply improving the ratio that one dealing with the significant issues.

2. Ratios can only provide guidelines to the management. They are only the means. However, they scratch surfaces and raise questions. This limitation of ratios may force the management to have detailed investigation of the situation under question.

3. The standards will differ from industry to industry. Comparison of ratios of firms belonging to different industries is not suggested.

4. Since ratios are calculated from past records, there are no indicators of the future.

5. Proper care should be exercised to study only such figures as have a cause and effect relationship, otherwise, ratios will only be meaningless or misleading.

6. The reliability and significance attached to ratios depends on the accuracy of data based on which ratios are calculated.

7. Ratios of a company can have meaning only when they are compared against standard. Past performance of the same company cannot be benchmarked when there is change in circumstances.

8. The change in price levels due to inflation will distort the reliability of ratio analysis.

9. The analyst should have through knowledge of methods of window-dressing.

10.Single accounting ratio is not useful at all, unless it is studied with other accounting ratios. This limitation of ratios necessitates inter-firm and intra-firm comparisons.

11. Ratios are based only on the quantitative information. Hence, qualitative information (i.e. character, managerial ability etc.) places a limit on the ratios.

12. Ratios are subject to arithmetical accuracy of the financial statements. Moreover, financial statements also include estimated data like provision for depreciation, for bad and doubtful debts, etc. Hence, results revealed by ratios are subject to such estimates.

13. Ratios are computed on the basis of financial statements which are historical in nature.

14. Knowledge of ratios alone in meaningless unless their composition is also ascertained.

15. Lack of homogeneity of data, personal judgment, lack of consistency, etc. is the factors that limit the conclusion to be derived on the basis of accounting ratios.

16. Rations are calculated form financial statements which are affected by the financial bases and policies adopted on such matters as depreciation and the valuation of stocks.

17. A ratio is a comparison of two figures, a numerator and a denominator. In comparing ratios, it may be difficult to determine whether differences are due to changes in the numerator, or in the denominator or in both.

18. Ratios are interconnected. They should not be treated in isolation. The effective use of ratios, therefore, depends on being aware of all these limitations and ensuring the following comparative analysis, they are used as a trigger point for investigation and corrective action, rather than being treated as meaningful in them.

19. The analysis of ratios clarifies trends and weaknesses in performance as a guide as long as proper comparisons are made the reasons for adverse treads or deviations from the norm are investigated thoroughly.

20. While making inter-firm comparison, the analyst must keep in mind that different firms follow different accounting policies, e.g., depreciation allowance, valuation of inventory, etc.

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