Ratio analysis is a widely used and useful
technique to evaluate the financial position and performance of any business
unit but it suffers from a number of limitations. These limitations must be kept
in mind by the analyst while using this technique.
Reliability is Linked with Accounting Data:
Ratios are calculated on the basis of
accounting information. Accounting system has certain in built limitations like
historical cost, going concern value, stable monetary value, etc. So,
limitations of accounting data affect the quality of ratios also. After, all
ratios can't be more reliable than the reliability of data itself.
Qualitative Factors are Ignored:
Ratio analysis is only a quantitative analysis.
Sometimes qualitative factors may be important. For example, management may be
justified in making huge purchases of raw material in anticipation of large
demand of its product for the coming period. But ratios are not capable of
considering qualitative factors.
Isolated Ratios is Meaningless:
Ratios assume significance only when studied in
proper context and if compared with norms or over a period. Ratio in itself does
not convey any sense.
Ratio Analysis is Historical:
Ratios are based on the facts contained in
financial statements. These statements contain
past records. Past may be less important or irrelevant for the management than
present and future.
Different Accounting Practice Render Ratios Incomparable:
Accounting permits alternative treatment of
many items like depreciation, valuation of tock, deferred expenses etc. Ratios
based on statements prepared by following different practices are not
Price Level Changes Affect the Utility of Ratio Analysis:
Comparison of ratios over a period of time
relating to same unit may be misleading. For example, sales may be static in
quantity but higher in dollar value due to inflation.
Incompetence or Bias of Analyst:
Much depends upon the skill, integrity and
competence of the analyst to use ratios judiciously.
Lack of Adequate Standards:
There are no well-accepted standards or rule of
thumb for all ratios which might be expected as norms for comparison. It renders
interpretation of ratios difficult and to some extent arbitrary.
Financial statements can easily be "window
dressed" to depict better than real picture of the enterprise. Moreover the
analyst depending only upon published financial statements will not be in a
position to get inside information.