What are the limitations of ratio analysis?

Answer 1

LIMITATIONS OF RATIO ANALYSIS

The analyst should be aware of limitations of ratio analysis.

Because ratios use financial statement data as inputs, the same factors that cause short-comings in financial statements will affect the ratios computed from them. Such short-comings, at least for some purposes, include the use of acquisition cost for assets rather than current replacement cost or net realizable value and the latitude firms have in selecting from among various generally accepted accounting principles.

2 . Changes in many ratios correlate with each other. For example, the current ratio and the quick ratio often change proportionally and in the same direction. The analyst need not compute all the ratios to assess a particular dimension of profitability or risk.

3 . When comparing the size of a ratio between periods for the same firm, the analyst must recognize conditions that have changed between the periods being compared (for example, different product lines or geographic markets served, changes in economic conditions, changes in prices, changes in accounting principles, and corporate acquisitions).

4 . When comparing ratios of a particular firm with those of similar firms, one must recognize differences among the firms (for example, different methods of accounting, different operating methods, and different types of financing).

Financial statement ratios alone do not provide direct indicators of good or poor management. Such ratios indicate areas that the analyst should investigate further. For example, a decrease in the turnover of merchandise inventory, ordinarily considered an undesirable trend, may reflect the accumulation of merchandise to keep retail stores open during anticipated shortages. Such shortages may force competitors to restrict operations or to close down. The analyst must combine ratios derived from financial statements with an investigation of other facts before drawing conclusions.