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.
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 it doesn’t take into consideration any contingent liability. A contingent liability is one that is dependent upon some external factors that 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 doesn’t take this into consideration, although such Contingent LiabilitiesContingent LiabilitiesContingent Liabilities are the potential liabilities of the company that may arise at some future date as a result of a contingent event that is beyond the company's control. 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 MethodStraight Line MethodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. will report different Net Profit, and Companies reporting depreciation based on the Declining Balance MethodDeclining Balance MethodIn declining balance method of depreciation or reducing balance method, assets are depreciated at a higher rate in the initial years than in the subsequent years. A constant depreciation rate is applied to an asset’s book value each year, heading towards accelerated depreciation. 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 StatementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels..
# 4 – Susceptible to Creative Accounting
- Accounting PoliciesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level. adopted by the companies have a material impact on Ratio Analysis. Financial Statements can be distorted by the companies using Creative AccountingCreative AccountingCreative accounting is a method used to make or interpret accounting policies falsely to misuse the accounting techniques and standards set by the accounting bodies. The purpose of doing so is to make profits by not reporting the exact figures and exploiting loopholes in our accounting system.. A company may opt for an Exceptional Income (Non-Recurring IncomeNon-Recurring IncomeNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off.) 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, businesses 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 procedures and policies adopted by the business. For instance, a company shifting from the LIFO Inventory method of ValuationLIFO Inventory Method Of ValuationLIFO (Last In First Out) is one accounting method for inventory valuation on the balance sheet. LIFO accounting means inventory acquired at last would be used up or sold first. to the FIFO method of Inventory ValuationFIFO Method Of Inventory ValuationUnder the FIFO method of accounting inventory valuation, the goods that are purchased first are the first to be removed from the inventory account. As a result, leftover inventory at books is valued at the most recent price paid for the most recent stock of inventory. As a result, the inventory asset on the balance sheet is recorded at the most recent cost. 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 is that it is not standardized for all industries. Different business operating in different Industries is difficult to interpret based on the standard Ratio AnalysisRatio AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.. For instance, companies operating in Real Estate will have a very low Return on Capital Employed (ROCEROCEReturn on Capital Employed (ROCE) is a metric that analyses how effectively a company uses its capital and, as a result, indicates long-term profitability. ROCE=EBIT/Capital Employed.) 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 A Current RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities 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 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.
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 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.‘), 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 –