Limitations of Ratio Analysis

Financial ratio analysis faces some limitations, which are given below:

(1) Ratio analysis requires a proper comparison i.e., one ratio its own is of no use unless it is compared to last year’s figures or other companies’ figure, etc.

(2) Comparison with last year’s or with competitors may not be valid because of using different accounting policies and methods.

(3) Ratios are based on historical figures (not adjusted for inflation) so the conclusions drawn from them may be misleading and unrealistic.

(4) Accounting ratios usually highlight past results and conditions which may not be useful for making projections for the coming periods.

(5) Outside influences e.g., conditions of national/world economy can affect ratios. However in such situations, retailers are usually affected before manufactures.

(6) The accuracy and reliability of ratios depend upon the quality and reliability of the data recorded in the financial statements. Moreover accounting data is limited to information having a monetary value.

(7) Ratios are only indicators; they should not be independently used to comment regarding good or bad financial position or performance of the business. Moreover they do not indicate the reasons of poor performance.

(8) Ratios have to be interpreted as the causes of changes in ratios are not revealed and different people may interpret the ratios in different ways. This depends a lot on the personal expertise, experience and judgmental power of the analyst. Inexperience analyst may arrive at false conclusion.

(9) Each industry has different standards for different ratios to be adhered to.