The following points highlight the nine major limitations of ratio analysis. The limitations are: 1. False Results if Based on Incorrect Accounting Data 2. No Idea of Probable Happenings in Future 3. Variation in Accounting Methods 4. Price Level Changes 5. Only One Method of Analysis 6. No Common Standards 7. Different Meanings Assigned to the Same Term and Others.
Limitations of Ratio Analysis:
- False Results if Based on Incorrect Accounting Data
- No Idea of Probable Happenings in Future
- Variation in Accounting Methods
- Price Level Changes
- Only One Method of Analysis
- No Common Standards
- Different Meanings Assigned to the Same Term
- Ignores Qualitative Factors
- No use if Ratios are worked out for Insignificant and Unrelated Figures
Limitations # 1. False Results if Based on Incorrect Accounting Data:
Accounting ratios can be correct only if the data (on which they are based) are correct. Sometimes, the information given in the financial statements is affected by window dressing, i.e., showing position better than what actually is.
For example, if inventory values are inflated or depreciation is not charged on fixed assets, not only will one have an optimistic view of profitability of the concern but also of its financial position. So the analyst must always be on the look-out for signs of window dressing if any.
Limitations # 2. No Idea of Probable Happenings in Future:
Ratios are an attempt to make an analysis of the past financial statements; so they are historical documents. Now-a-days keeping in view the complexities of the business, it is important to have an idea of the probable happenings in future.
Limitations # 3. Variation in Accounting Methods:
The two firms’ results are comparable with the help of accounting ratios only if they follow the same accounting methods or bases. Comparison will become difficult if the two concerns follow the different methods of providing depreciation or valuing stock.
Similarly, if the two firms are following two different standards and methods, an analysis by reference to the ratios would be misleading. Moreover, utilisation of inbuilt facilities, availability of facilities and scale of operation would affect financial statements of different firms. Comparison of financial statements of such firms by means of ratios is bound to be misleading.
Limitations # 4. Price Level Changes:
Changes in price levels make comparison for various years difficult. For example, the ratio of sales to total assets in 1996 would be much higher than in 1982 due to rising prices, fixed assets being shown at cost and not at market price.
Limitations # 5. Only One Method of Analysis:
Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making. So, to have a comprehensive analysis of financial statements, ratios should be used along with other methods of analysis.
Limitations # 6. No Common Standards:
It is very difficult to lay down a common standard for comparison because circumstances differ from concern to concern and the nature of each industry is different. For example, a business with current ratio of more than 2 : 1 might not be in a position to pay current liabilities in time because of an unfavorable distribution of current assets in relation to liquidity.
On the other hand, another business with a current ratio of even less than 2 : 1 might not be experiencing any difficulty in making the payment of current liabilities in time because of its favourable distribution of current assets in relation to liquidity.
Limitations # 7. Different Meanings Assigned to the Same Term:
Different firms, in order to calculate ratio may assign different meanings. For example, profit for the purpose of calculating a ratio may be taken as profit before charging interest and tax or profit before tax but after interest or profit after tax and interest. This may affect the calculation of ratio in different firms and such ratio when used for comparison may lead to wrong conclusions.
Limitations # 8. Ignores Qualitative Factors:
Accounting ratios are tools of quantitative analysis only. But sometimes qualitative factors may surmount the quantitative aspects. The calculations derived from the ratio analysis under such circumstances may get distorted.
For example, though credit may be granted to a customer on the basis of information regarding his financial position, yet the grant of credit ultimately depends on debtor’s character, honesty, past record and his managerial ability.
Accounting ratios may be worked for any two insignificant and unrelated figures as ratio of sales and investment in government securities. Such ratios may be misleading. Ratios should be calculated on the basis of cause and effect relationship. One should be clear as to what cause is and what effect is before calculating a ratio between two figures.