Limitations of Ratio Analysis | Accounting

Some of the limitations of the ratio analysis are:- 1. Differences in Definitions 2. Limitations of Accounting Records 3. Lack of Proper Standards 4. No Allowances for Price Level Changes 5. Changes in Accounting Procedure 6. Qualitative Factors are Ignored 7. Limited Use of Single Ratio 8. Background is Overlooked 9. Limited Use 10. Personal Bias 11. Arithmetical Window Dressing 12. Changing Policies

1. Differences in Definitions:

Comparisons are made difficult due to differences in definitions of various financial terms. Lack of standard formula for working out ratios makes it difficult to compare them. They are worked out on the basis of different items in different industries.

2. Limitations of Accounting Records:

Ratio analysis is based on financial statements which are themselves subject to limitations. Thus, ratios calculated on the figures given in the financial statements, also suffers from similar limitations.

3. Lack of Proper Standards:

It is very difficult to ascertain the standard ratio in order to make proper comparison. Because, it differs from firm to firm, industry to industry. Apart from this, it may also have happened that in one firm, a current ratio of 2:1 is found to be quite satisfactory, whereas in another firm 2.5:1 may be unsatisfactory. Again, a high current ratio may not necessarily mean sound liquid position when current assets include large inventory or inventory consisting of obsolete items.

4. No Allowances for Price Level Changes:

Due to changes in price level of various years, comparison of ratios of such years cannot give correct conclusions. A change in the price level can seriously affect the validity of comparisons of ratios computed for different time periods. For instance, a firm which has purchased an asset at a lower price, will show a higher return, than the firm which has purchased the asset at a higher price.

5. Changes in Accounting Procedure:

Comparison between two variables proves worth provided their basis of valuation is identical. But in reality, it is not possible, such as methods of valuation of stock (FIFO or LIFO) or charging different methods of depreciation on fixed assets etc. Thus, if different methods are followed by different firms for their valuation, then comparison will practically be of no use.

6. Qualitative Factors are Ignored:

Ratios are tools of quantitative analysis only and normally qualitative factors which may generally influence the conclusions derived are ignored while computing ratios. For instance, a high current ratio may not necessarily mean sound liquid position when current assets include a large inventory consisting of mostly obsolete items. Therefore, it is very difficult to generalize whether a particular ratio is good or bad.

7. Limited Use of Single Ratio:

A single ratio would not be able to convey anything. Ratios can be useful only when they are computed in a sufficient large number. If too many ratios are calculated, they are likely to confuse instead of revealing meaningful conclusions.

8. Background is Overlooked:

When inter-firm comparison is made, they differ substantially in age, size, nature of product etc. When an inter-firm comparison is made, these factors are not considered. Therefore, ratio analysis cannot give satisfactory results.

9. Limited Use:

Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making. Ratio analysis is not a substitute for sound judgement. But ratios are tools to aid in applying judgement. Conclusions drawn from the ratio analysis are not sure indicators of bad or good management. They merely convey certain observations which need further investigations, otherwise wrong conclusions may be drawn. Computations of ratios are not useful unless they are interpreted.

10. Personal Bias:

Ratios have to be interpreted and different people may interpret the same ratio in different ways. Ratios are only means of financial analysis but not an end in themselves. Ratios are simple to understand and easy to calculate. Therefore, there is a tendency to over employ them. It should be clearly noted that ratios are only tools and the personal judgement of analyst is more important. The analyst has to carry further investigations and exercise his judgement in arriving at a correct diagnosis.

11. Arithmetical Window Dressing:

Window-dressing means manipulation of accounts in a way so as to conceal vital facts and present the statements in a way to show better position than what it actually is. By doing so, it is possible to cover up bad financial position. Therefore, ratios based on such figures are not reliable.

12. Changing Policies:

Ratios are computed on the basis of past result. Past is not an indicator of future. Ratios computed from historical data are used for predicting and projecting the likely events in the future. Such ratios may provide a glimpse of firm’s past performance. But forecast for the future may not be correct as several other factors like management policies, market conditions etc. may induce future operations.

Ratios are only a post-mortem of what has happened between two Balance Sheet dates. The position in the interim period is not revealed by ratio analysis. Besides, they give no clue to future. Ratio analysis suffers from serious limitations. The analyst should not be carried away by its oversimplified nature, easy computation with a high degree of precision. They are as good as data itself.

The analyst must have comprehensive but practical knowledge and experience about the concerns whose statements have been used for calculating these ratios. Ratios are not an end in themselves but they are means to achieve a particular end. Another limitation is that of standard ratio with which the actual ratios may be compared.

Generally, there is no such ratio which may be treated as standard for the purpose of comparison, because conditions of one concern differ significantly from those of another concern. The analyst must be able to examine the nature of the data carefully.

If accounting data lack uniformity particularly definitional uniformity, then ratios calculated on the basis of them will be misleading. Ratio analysis is one of the many techniques of analysis and interpretation. Thus, while attempting to draw any conclusion on this basis, other techniques should also be used.