Limitations of Ratio Analysis

Meaning of Ratio Analysis

Ratio analysis is a very powerful analytical tool for measuring performance of an organization. The ratio analysis concentrates on the inter-relationship among the figures appearing in the above mentioned and various other statements. It helps the management to analyze the past performance of the firm and to make further projections.

Ratio analysis allows interested parties like shareholders, investors, creditors, government and analysts to make an evaluation of certain aspects of a firm’s performance. The calculation of ratios is a relatively easy and simple task but the proper analysis and interpretation of ratios can be made only by skilled analyst. While interpreting the financial information, the analyst has to be careful about limitations imposed by the accounting concepts and methods.of valuation.

Information of non-financial nature will also be taken into consideration before a meaningful analysis is made.Ratio analysis pinpoints the strengths and weaknesses of the business mainly in two ways. Firstly, by comparing current performance with that of past and secondly by comparing the performance of the business with that of the industry as whole or other firms in the industry.

Limitations of Ratio Analysis

  • It is based on financial statements which are themselves subject to severe limitations.Therefore, any ratio analysis based on a misstatement suffers from the similar limitations.
  • In case of inter-firm comparison, no two firms are similar in age, size and product unit. Therefore, any comparison of ratios of two such firms must take these factors into account.
  • Both, the inter-period and inter-firm comparisons are affected by price level changes. A change in the price level can affect the validity of ratios calculated for different time periods.
  • The ambiguity in defining terms like gross profit, capital employed, operating profit, current assets etc. also leads to distortions in the ratio analysis and ratios based on different concepts can be misleading.
  • Any decision cannot be taken based on a single ratio. The analyst has to use various ratios and other forms of accounting analysis before taking any decision.
  • Conclusions from analysis of statements are sure indicators of bad or good management.
  • Ratio analysis is only a tool and is helpful to spot out the symptoms. The analyst has to carry out further investigations and exercise his judgement in arriving at a correct diagnosis.