Ratio analysis is a 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. Similarly, ratio analysis is also used by investors to make an informed choice before investing in a company. Therefore, it makes sense to understand the limitations of ratio analysis.
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- 1 DISADVANTAGES OR LIMITATIONS OF RATIO ANALYSIS ARE AS FOLLOWS:
DISADVANTAGES OR LIMITATIONS OF RATIO ANALYSIS ARE AS FOLLOWS:
There is no doubt that ratio analysis gives great insights about a company. Having said that, it also has a few limitations.
Inflationary Effects Not Taken into Consideration
Financial records are made over a period of time. These records may not give a true picture because effects of inflation are not taken into account while recording transactions. Assets purchased years back are recorded at historical rates in the balance sheets. These rates may not have the same value currently due to inflation. The value of inventory and depreciation may not have the same value now as it had at the time it was recorded.
Ratio Analysis not Useful While Comparing Companies Belonging to Different Industries
You cannot compare apples with oranges. Similarly, if you are comparing the ratios of companies belonging to different industries, you may be fighting a lost cause. Different industries have a different market, gestation periods, capital structure etc. For ratio analysis to hold any meaning, you need to compare companies belonging to the same industries only.
The difference in Accounting Practices
Different companies may use different accounting practices. Inventory valuation methods may differ and so can depreciation methods. As a result, comparing ratios of such companies may not depict a correct picture.
Ratio analysis can be done using what is present in the financial statements of a company. Financial statements can easily be fudged or window-dressed to hide or misrepresent facts. Ratio analysis is no way equipped to detect this. If you analyze a manipulated balance sheet or income statement, you are bound to get wrong information. Window dressing is in no way an accepted practice but many companies do indulge in such malpractices to give a false impression to their investors.
E.g., a company may delay paying its creditors at the end of a financial year. This way, the company can show more cash balance on its balance sheet. This is the simplest form of window dressing.
A Quantitative Measure, not a Qualitative One
Ratio analysis is a quantitative measure. At best, it can make sense out of the financial statements. It cannot give a cause or a reason if something is lacking or what needs to be done to correct the situation. Unless you dig into the ratios, it makes very little sense to perform ratio analysis.
E.g., profitability ratios may suggest that you have a lower profit compared to your competitors. This does not help in finding the actual cause of this and what corrective actions need to be taken. Lower profit may be because of the wrong pricing structure, the marketing team may not be doing its task, the production quality is not up to the mark etc. So, one needs to dig into the ratios to find the actual cause of the problem. Simple ratio analysis may not suffice.