The following points highlight the nine major limitations of ratio analysis.
Some of the limitations of financial ratios are as follows: Financial statement analysis through ratios is useful because they highlight relationships between items in the financial statements.
However, they have a number of limitations which should be kept in mind while preparing or using them. Therefore, ratios are not very helpful in drawing reliable conclusions. Companies otherwise similar may employ different accounting methods, which can cause problems in comparing certain key relationships.
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.
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.
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.Limitations of Ratio Analysis: The technique of ratio analysis is a very useful device for making a study of the financial health of a firm.
But it has some limitations which must not be lost sight of before undertaking such analysis. Ratio Analysis Benchmarking Evaluating ratios requires comparison against some benchmark.
Such benchmarks include: Ratios of other firms in the industry (cross-sectional) Ratios over time from prior periods (time series) Effectiveratio analysis must attempt to relate underlying business factors to the financial numbersHowever, benchmarking has.
The limitations of ratio analysis January 17, / Steven Bragg Ratio analysis can be used to compare information taken from the financial statements to gain a general understanding of the results, financial position, and cash flows of a business.
Discusses the limitations of financial ratio analysis. Learn how benchmarking financial ratios can increase the benefit from analysis. CFA Level 1 - . Limitations of Ratio Analysis Ratio analysis is widely used tool to analyze the performance of a company.
It is used by the company management to see where its company lies in comparison with its competitors and also find out the areas where it is lacking and needs to work on. Ratio analysis is widely used in practice in business.
Teams of investment analysts pour over the historical and forecast financial information of quoted Teams of investment analysts pour over the historical and forecast financial information of quoted companies using ratio analysis as part of their toolkit of methods for assessing financial performance.