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Limitations of Ratio Analysis

LIMITATIONS OF RATIO ANALYSIS

  1. Limitations of financial statements. Ratios are usually calculated on the past year’s financial data contained in the financial statement. In the real sense, financial statements suffer a number of limitations. When ratios are derived from the financial statements, they also suffer from the same limitations.
  2. Differences in Definition. There is no clear cut formula for computing ratios. Each and every company follows a separate formula for computing different ratios. Due to these different types of formulas, comparison of different industries becomes difficult.
  3. Ratios alone are not adequate. Various tools are available for evaluating the financial performance of a company. Under this aspect, ratios are tools of quantitative analysis only. Normally qualitative factors which may generally influence the arrival of conclusion are ignored while computing ratios.
  4. Problems of price level changes. Even though there are certain limitations, inflation is utmost important for industrial and economic development of the country. Due to this aspect, price fluctuation could not be eliminated. Ratios fail to reflect the price level changes as they are based on Historical data. Hence, they may give misleading results when inflationary conditions are ignored.
  5. It is not substitute for personal judgment. It is only a beginning and gives limited information for decision making. It is just an aid and cannot replace thinking and personal judgment employed in the decision making aspect.
  6. Ratios can be manipulated. There will be a great demand for goods during the festival season when compared to previous periods. Suppose this inventory turnover ratio is considered for decision making, the results get distorted. It is necessary to take the average inventories to present a fair view of the business activity.

Despite certain limitations, ratio analysis continues to be a powerful tool for analysis and interpretation of financial statements.