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# Limitations of Ratios Analysis:

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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 comparable.

## 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.

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.

## Window Dressing:

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.

More study material from this to

## More study material from this topic:

 Meanings, Nature and Usefulness of Ratios Analysis Interpretation of Ratios Important Factors for Understanding Ratios Analysis Significance and Usefulness Ratios Analysis Classification of Ratios Analysis of Short Term Financial Position or Test of Liquidity Current Ratio Quick/Acid Test/Liquid Ratio Absolute Liquid Ratio Inventory/Stock Turnover Ratio Debtors / Receivable Turnover Ratio Creditors / Payables Turnover Ratio Working Capital Turnover Ratio Profitability Ratios Gross Profit Ratio (GP Ratio) Operating Profit Ratio Net profit ratio (NP ratio) Earnings Per Share Ratio Operating ratio Expense ratio Solvency ratios - Test of Long Term Solvency Debt-equity Ratio Debt Service Ratio or Interest Coverage Ratio Fixed Assets Ratio Debts to Total Funds or Solvency Ratio Reserves to Capital Ratio Capital Gearing Ratio Proprietary Ratio Accounting Ratios Formulas Limitations of Ratios Analysis

A D V E R T I S E M E N T

 Financial Accounting Topics Introduction to Accounting ---------------------------------------------------------------------------- Transactions and Accounting Equation ---------------------------------------------------------------------------- Analysis of Business Transactions ---------------------------------------------------------------------------- Journal, Ledger and Trial Balance ---------------------------------------------------------------------------- Accounting for Bills of Exchange ---------------------------------------------------------------------------- Special Journals ---------------------------------------------------------------------------- Cash Book ---------------------------------------------------------------------------- Bank Reconciliation Statement ---------------------------------------------------------------------------- Final Accounts ---------------------------------------------------------------------------- Work Sheet ---------------------------------------------------------------------------- Capital and Revenue Items ---------------------------------------------------------------------------- Valuation of Inventories ---------------------------------------------------------------------------- Accounts of Non-profit Making Organizations ---------------------------------------------------------------------------- Statement of Cash Flows ---------------------------------------------------------------------------- Accounting Ratios Analysis ---------------------------------------------------------------------------- Depreciation, Provisions and Reserves ---------------------------------------------------------------------------- Accounting Dictionary ---------------------------------------------------------------------------- Financial Calculators

 Managerial Accounting Topics Financial Statements ---------------------------------------------------------------------------- Cost Volume Profit Relationship ---------------------------------------------------------------------------- Variable Costing System ---------------------------------------------------------------------------- Materials and Inventory Cost Control ---------------------------------------------------------------------------- Activity Based Costing System ---------------------------------------------------------------------------- Standard Costing and Variance Analysis ---------------------------------------------------------------------------- Balanced Scorecard ---------------------------------------------------------------------------- Capital Investment Analysis/Capital Budgeting

A D V E R T I S E M E N T