Limitations of Ratio Analysis
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 limitations.
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
- Another limitation of Ratio Analysis is that doesn’t take into consideration any contingent liability. A contingent liability is one which is dependent upon some external factor which may or may not happen such as Litigation matters etc.
- Such events if results in an adverse outcome for the business will have serious repercussions on the company’s financials, but Ratio Analysis don’t take this into consideration, although such Contingent Liabilities may have a material impact on the Financial Position of the company.
#3 – Doesn’t incorporate Uniform Accounting Policies
- Ratio Analysis doesn’t incorporate the impact of Accounting policies adopted by the business in recognizing Income and Expenses and as such the resultant comparison between the companies based on Ratio Analysis will be biased and will not exhibit the true comparison between the companies.
- For instance, Companies reporting depreciation based on the Straight Line Method will report different Net Profit and Companies reporting depreciation based on Reducing Balance Method will report a different Net profit. Similarly, Companies exposed to currency movements will be impacted differently but Ratio Analysis will not be able to capture the same in Financial Statements.
# 4 – Susceptible to Creative Accounting
- Accounting Policies adopted by the companies have a material impact on Ratio Analysis. Financial Statements can be distorted by the companies using Creative Accounting. A company may opt for an Exceptional Income (Non-Recurring Income) as a part of its Revenue and may declassify a Business Expenditure into a Non-recurring Expenditure which can materially impact its Financial Statements and the resultant Ratio Analysis. By choosing such accounting policies business deliberately abuse the subjectivity inherent in Accounting which tends to bias the figures in the direction opted by the management.
- Ratio Analysis becomes incomparable if there is a significant change in the Accounting policies and procedures adopted by the business. For instance, a company shifting from LIFO Inventory method of Valuation to FIFO method of Inventory Valuation will observe a significant variation in its profitability and Liquidity ratios during Inflationary periods and vice versa which will make the trend analysis exercise futile.
#5 – Cannot use to compare different industries
- Another limitation of ratio analysis is that it is not standardized for all the industries. Different business operating in different Industries is difficult to interpret based on the standard Ratio Analysis. For instance companies operating in Real Estate will have a very low Return on Capital Employed (ROCE) as the assets held by such companies are updated on a regular basis which results in an increase in the amount of capital employed; however there are certain Industries where assets are not required to be revalued at such frequency which makes it very difficult to compare based on Ratio Analysis.
- Ratio Analysis standards are not the same across Industries and it is difficult to compare companies based purely on their Standard Financial Ratios. For instance, a company in the Trading business may have a Current Ratio of 3:1 might appear to be excellent compared to a company in Real Estate with a Current Ratio of maybe 1:1 as ratio Analysis doesn’t take into consideration the particular dynamics of the business and Industry to which the companies relate to.
#6 – Only based on Historicals
- Another Ratio Analysis 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 the 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 major limitation of Ratio analysis 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 Historical Cost and Income Statement which shows the performance for the whole year at current cost.
- Analyzing such ratios can create a lot of disparity among the intended users.
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 incorrect analysis of the business.
This has been a guide to Limitations of Ratio Analysis. There are the top 10 financial 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 –