Read this article to learn about the seven limitations of ratio analysis.
Ratios are mainly calculated from the information recorded in the financial statements. As financial statements suffer from a number of limitations, such limitations may affect the quality of ratio analysis.
For example, the financial statements do not reveal non-financial changes though important for the business. Hence, the ratio analysis may fail to serve its purpose fully.
Ratios gain significance only when they are compared with other ratios or standards. But it is very difficult to lay down fixed standard for ideal ratios. Also ratios share with statistical concepts all the limitations of the latter.
Ratios are tools of quantitative analysis only and normal qualitative factors that may generally influence conclusions derived are ignored while computing ratios.
For example, a high current ratio may not necessarily mean sound liquid position when current assets include a large inventory consisting of mostly obsolete items. Hence, it is very difficult to generalize whether a particular ratio is ‘good’ or ‘bad’.
There are no standard formulae for working out ratios and it makes comparison very difficult. They are worked out on the basis of different items in different industries.
In addition, the number of ratios is so large that the task of selecting appropriate ratios for different units becomes very difficult. Ratios also fair to indicate clearly the point where the error lies.
Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making. It is just an aid and cannot replace thinking and personal judgment employed in the decision-making process.
Ratios fail to reflect the price level changes as they are based on historical data. Hence, they may give misleading results when inflationary conditions are ignored.
Comparison of two firms set up in different years through ratio analysis may not be meaningful, since the values of assets and liabilities of the two companies may not be comparable.
Ratios computed from historical data are used for predicting and projecting the likely events in the future. Such ratios may provide only a glimpse of a firm’s past performance, but the forecast for the future may not be correct since several other factors like management policies, economic and market conditions, etc., may induce future operations.
It may be concluded that ratio analysis, if not done properly or done mechanically, would be both misleading and dangerous. It is an aid to management to take correct decisions, but as a mechanical substitute for personal judgment and thinking, it would be worse than useless.