Ratio Analysis Limitations

Top 10 Limitations of Ratio Analysis

There are certain limitations for ratio analysis as 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 on the basis of an analysis of ratios.

Ratio Analysis is one of the most commonly used tools for analysis of Financial Statements, and it helps in depicting 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.

Ratio Analysis (Limitations)

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Below are the top 10 limitations of ratio analysis

#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 give consideration to 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 take into consideration such factors which have an impact on the Company’s performance.

#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 altogether 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. Many businesses are impacted by Seasonality factors, and Ratio Analysis fails to factor the same resulting in a false interpretation of the results of such a Ratio Analysis.
  • For instance, a company operating in the business of Woollen garments will observe sudden in Inventory levels before the Winter Season as large production is done in advance to meet the supply of Woollen garments in peak season. Such Inventory levels, if compared with other months, will show an unlikely spike in Inventory levels if seasonal factors are not taken into consideration, which Ratio Analysis fails to undertake on their own.

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

  • Ratio Analysis makes use of 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.

Conclusion

Ratio Analysis is based on the Financial Statements prepared by the company, and they take into consideration only the quantitative side of the business and completely ignore the qualitative factors of the business, which are equally important as well. Furthermore, the quality of Financial Statements determine the accuracy of Ratio Analysis, and if the financial statements are manipulated by the business or presented to show a position which is better than the actual (also Known as ‘Window Dressing‘), any ratios computed on such Business Financials will also result in an incorrect analysis of the business.

This article has been a guide to Limitations of Ratio Analysis. There are the top 10 ratio analysis limitations, including not considering business size, contingent liabilities, seasonality, the effect of changes in accounting policies, and more. You may learn more about Ratio Analysis from the following articles –

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