Limitations of Ratio Analysis

>> December 8, 2011


Ratio analysis is used by almost all the accounts managers for strategic planning and decision making. It also very helpful tool to know the effect of each item of financial statements by creating relationship  with other items. There is big list of benefits of ratio analysis but it has also some limitations. So, account managers and other parties who use ratio and its analysis should remember these limitations when they take any decision.

Following are main drawbacks or limitations of ratio analysis:

Limited Use of Single Ratio


Sometime, we can not compare our ratios with others. For example, we have started new business and our financial results are not still normal. At that time, our profitability ratio will have limited use because there is not any past data of profitability ratios.


Lack of Adequate Standards 

We could not make standards of all ratios. For example, we can not tell what is rule of them of our net profit ratio because there are lots of factors affect it. In the lack of adequate standards of ratios, we can not give exact comment on the basis of ratio analysis.

 Inherent Limitation of Financial Accounting 

Ratio analysis is just like simplification of financial accounting data. But there are lots of limitations of financial accounting which you can read at here. All these limitation will be absorbed by ratios. This is the one of the important limitation of ratio. I can say if base is not good, everything will be wrong. If there is small portion of poison in milk, its effect will be in everything what you will make.

Changes of Accounting Procedures 

If accounting procedures will change, our accounting ratio will be changed. At that time, we can not compare our current year ratios with our past year ratios. For example, in past year, we had used LIFO but current year, we are using FIFO for inventory valuation. Due to this, figures of closing stock will be different. On this basis, if we have calculated current ratio, it will not be comparable with past current ratio.

Window Dressing

Because we have shown our financial data through window dressing. Our ratios will also be affected from it.

 Personal Bias 

This is reality, I saw many CAs who waste their time to optimize different ratios by changing the project financial statements figures for making attractive projects. All these activities are done for getting loan. So, this will make the drawback of ratio analysis.

  Matchless

Different companies uses different accounting policies, so, we can not compare their ratios.

 Price Level Changes 

Inflation effect is ignored in calculation of ratios. So, ratio will not give perfect answer in changing of price level.

Ratios are not Substitute of Financial Statements 

Ratio analysis is important part of financial statements analysis. It can never become a substitute of financial statements. We just use it with cash flow analysis, fund flow analysis and other analysis.

 Wrong Interpretation 

We can interpretate wrongly. For explaining the effect on company's position with ratios, there is big need of experience. Wrong interpretation will be helpful for wrong decisions. So, it is limitation of ratio analysis that it does not explain all the facts, it has to explain. For a new accounts manager, it may be difficult.






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3 comments:

Roshni Bhatia February 20, 2012 at 8:00 AM  

Ratios form the base of financial management and its essential to understand the limitations of ratios. Good article, thanks.

Nelson Kinyamagoha December 17, 2012 at 12:50 PM  

very nice, readable and understanding notice!

Sarah Ahmed March 28, 2014 at 10:47 PM  

I came across your site by searching Google for the limitation of ratio analysis and going through your article from A to Z. I thin it is very good presentation of limitations of ratio analysis out there. Thanking you.

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