The following points highlight the five major limitations of financial ratios.
1. Accounting ratios are based on accounting figures given in the financial statements. However, accounting figures are themselves subject to deficiencies, approximations, diversity in practice or even manipulation to some extent. Therefore, ratios are not very helpful in drawing reliable conclusions.
2. Accounting ratios have inherent problem of comparability. Companies otherwise similar may employ different accounting methods, which can cause problems in comparing certain key relationships. For example, inventory turnover can be different for a company using FIFO than for the other company using LIFO method of inventory valuation.
Similarly the differences in accounting methods relating to depreciation, estimates of the life of asset, amortisation of intangibles and preliminary expenses, treatment of extraordinary items etc. can create the problem of comparability among the companies even in the same industry.
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3. Inflation may limit the utility of accounting ratios. Due to inflation, historical cost-based financial statements and accounting figures do not reflect current value figures, especially in the case of assets purchased at different dates by the different enterprises.
Since financial statements are not adjusted in terms of inflation effect, accounting ratios calculated (using varying cost or prices) have distortions and become deceptive. Sometimes, gains (reflected through ratios) over time in sales, net income and other key figures disappear when the accounting data are adjusted for changes in price levels.
4. Accounting ratios are not totally dependable and they must be used after giving due weightage to general economic conditions, industry situation, position of firms within the industry, mode of operations, size of firm, diversity of product which can make the business enterprises completely dissimilar and thus affect the computation of accounting ratios.
5. The different methods of computation also influence the utility of accounting ratios. The different concepts used for determining numerator and denominator in a particular accounting ratio will not help in drawing reliable conclusions even in identical situations.