Ratio Analysis Limitations

Article byDheeraj Vaidya, CFA, FRM

What Are Ratio Analysis Limitations?

Ratio Analysis Limitations refer to the restrictions taken into consideration while computing the ratio analysis. It only considers quantitative aspects and fully ignores the qualitative aspects, it does not take into consideration the reasons for fluctuation of amounts due to which results may not be appropriate, and it only shows the comparison or trend, actions have to be taken afterward by management based on an analysis of ratios.

Ratio Analysis (Limitations)

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Ratio Analysis is one of the most commonly used tools for the analysis of Financial Statements. It helps depict the most critical financial parameters of the business at a glance. However, despite being such a popular and useful technique for the interpretation of Financial Statements, Ratio Analysis has its own set of limitations.

Key Takeaways

  • Ratio analysis has limitations as it solely focuses on quantitative factors and overlooks qualitative aspects. Management must carefully scrutinize ratios and investigate reasons for fluctuations before making decisions.
  • While ratio analysis is crucial for assessing a company’s financial statements, it’s equally important to consider qualitative factors that impact the company’s performance.
  • The accuracy of ratio analysis relies on the quality of financial statements. If the financial statements are manipulated, it can lead to inaccurate business analysis, highlighting the significance of reliable and transparent financial reporting.

Ratio Analysis Limitations Explained

Ratio analysis limitations, when listed, refer to the lists of factors that restrict the ratio analysis computations in some way. These restrictions tell one about how and where the ratio analysis calculations can go wrong.

Ratio Analysis is based on the Financial Statements prepared by the company. They consider only the quantitative side of the business and completely ignore the qualitative factors of the business, which are equally important. Furthermore, the quality of Financial Statements determines the accuracy of Ratio Analysis. Suppose the financial statements are manipulated by the business or presented to show a better position than the actual (also Known as ‘Window DressingWindow DressingWindow dressing in accounting refers to the intentional manipulation of financial statements by company management in order to present a more favourable picture of the company to users of the financial statement before it is released to the public.read more‘). Any ratios computed on such Business Financials will also result in an incorrect analysis of the business.

Ratio analysis is one of the most significant metrics that help evaluate the financial state of a business. It helps businesses compare themselves with their competitors. As a result, they learn about the loopholes and work on them to improve their market position.

The ratio analysis is a vital valuation parameter for both the management of the businesses and their investors. Based on the analysis of different ratios that a firm calculates and presents in its financial statements, the investors decide whether to invest in a firm’s asset or not. In addition, it guides the management of the companies to assess their strategies and check if they are good to go in the current business scenario. If required, the management transforms startegies for betterment and improvement.

The role that ratio analysis plays in helping the businesses assess their current position and make comparisons with peers, it is important to ensure that the computations are correct with respect to the limitations that calculations involve.

Top 10 Ratio Analysis Limitations

Understanding the restriction of ratio analysis can help companies know the factors that influence the ratio analyses that they conduct. Hence, the firms remain prepared to face unexpected outcome, given the ignorance of certain factors.

The top 10 limitations that one must know of are as follows:

#1 – Doesn’t consider the size of the Business

  • Ratio Analysis diverts the attention of the intended user from the figures and financial statements of the business as they don’t consider the size of the business and the resultant bargaining power and economies of scale that a large business enjoys compared to a Small business. It doesn’t consider such factors that have an impact on the Company’s performance.

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#2 – Doesn’t take into account Contingent Liability

#3 – Doesn’t incorporate Uniform Accounting Policies

# 4 – Susceptible to Creative Accounting

#5 – Cannot use to compare different industries

#6 – Only based on Historicals

  • Another limitation is that it is based on historical figures reported by the business and, as such, predicts that the history will repeat itself, which may or may not be the case. Also, such figures are irrelevant when a business has changed its business model or entered into a different line of business.

#7 – Doesn’t consider the impact of Inflation

  • Ratio Analysis doesn’t incorporate the impact of Price rise, i.e., Inflation. If an increase in Sales is purely on account of Inflation, Revenues of the business would appear to have increased over the previous year when, in fact, the Revenues would have remained constant in real terms.

#8 – Doesn’t Consider Impact of Market Conditions

  • Ratio Analysis doesn’t incorporate the impact of the market conditions on business performance. For instance, an increase in the Company’s Outstanding Debt Receivables during an economic boom cycle when sales increase will be considered bad compared to a recessionary period.

#9  – Failure in capturing the impact of Seasonality

  • Another limitation is its failure to capture seasonality. Seasonality factors impact many businesses, and Ratio Analysis fails to factor the same resulting in a false interpretation of such a Ratio Analysis.
  • For instance, a company operating in Woollen garments will observe sudden Inventory levels before the Winter Season as large production is done in advance to meet the supply of Woollen garments in peak season. Compared with other months, such Inventory levels will show an unlikely spike in Inventory levels if seasonal factors are not taken into consideration, which Ratio Analysis fails to undertake on its own.

#10 – Considers the position of the business on a particular date

  • Ratio Analysis uses Balance Sheet values, which are the position of the business on a particular date, and most of the values are shown at the Historical Cost and Income Statement, which shows the performance for the whole year at the current cost.
  • Analyzing such ratios can create a lot of disparity among the intended users.

Frequently Asked Questions (FAQs)

1. What are the main limitations of ratio analysis as a tool for financial evaluation?

Ratio analysis has limitations as it relies solely on historical financial data, may not capture qualitative factors, and does not account for external economic factors. Additionally, differences in accounting policies and practices between companies can affect the comparability of ratios.

2. Can ratio analysis alone provide a complete picture of a company’s financial health?

While ratio analysis is a valuable tool, it cannot provide a complete picture of a company’s financial health on its own. It should be complemented with other financial metrics, qualitative analysis, and a thorough understanding of the industry and economic conditions for a more comprehensive evaluation.

3. Can ratio analysis provide insights into a company’s long-term sustainability?

Ratio analysis can offer some insights into a company’s long-term sustainability by assessing profitability, solvency, and efficiency. However, it may not account for factors like innovation, market trends, and management’s strategic decisions that significantly affect a company’s long-term success. A broader analysis is necessary to evaluate long-term sustainability.

This article has been a guide to what are Ratio Analysis Limitations. Here, we explain the concept along with discussing the list of top 10 limitations. You may learn more about Ratio Analysis from the following articles –

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