Limitations of Financial Ratio Analysis


1) False Results:

If Financial Statements are not correct Financial Ratio Analysis will also be correct.

2) Different meanings are put on different terms:

Elements and sun-elements are not uniquely defined. An enterprise may work out ratios on the basis of profit after Tax and interest while others work on profit before interest and Tax .So, the Ratios will also be different so cannot be compared. But before comparison is to be done the basis for calculation of ratio should be same.

3) Not comparable if different firms follow different accounting Policies. Two enterprises may follow different Policies like some enterprises may charge depreciation at straight line basis while others charge at diminishing value. Such differences may adversely affect the comparison of the financial statements.

4) Affect of Price level changes: Normally no consideration is given to price level changes in the accounting variables from which ratios are computed. Changes in price level affects the comparability of Ratios. This handicaps the utility of accounting ratios.

5) Ignores qualitative factors:  Financial Ratios are on the basis of quantitative analysis only. But many times qualitative facts overrides quantitative aspects .For Example: Loans are given on the basis of accounting Ratios but credit ultimately depends on the character and managerial ability of the borrower. Under such circumstances, the conclusions derived from ratio analysis would be misleading.

6) Ratios may be worked out for insignificant and unrelated figures.  Example: A ratio may be worked out for sales and investment in govt. securities. Such ratios will only be misleading. Care should be exercised to work out ratios between only such figures which have cause and effect relationship. One should be reasonably clear as to what is the cause and what is the effect.

7) Difficult to evolve a standard Ratio:  It is very difficult to evolve a standard ratio acceptable at all times as financial and economic scenario are dynamic. Again the underlying conditions for different firms and different industries are not similar, so an acceptable standard ratio cannot be evolved.

8) Window Dressing:  Financial Ratios will be affected by window dressing. Manipulations and window dressings affect the financial statements so they are going to affect the f. ratios also. Therefore a particular ratio may not be a definite indicator of good or bad management.

9) Personal Bias:  Ratios have to be interpreted, but different people may interpret same ratios in different ways. Ratios are only tools of financial analysis but personal judgment of the analyst is more important. If he does not posses requisite qualifications or is biased in interpreting the ratios, the conclusion drawn prove misleading






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