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Limitations of Ratio Analysis

The ratio analysis is not a fool-proof method in financial statements analysis. Inspire of many good points, it suffers from a number f limitations which arise from the nature fo financial information itself. Some of the important limitations are given below:

1.    Ratios ignore qualitative factors: The ratios are obtained from the figures expressed in money. In this way, qualitative factors, which may be important, are ignored. For instance, it is just possible that money, yet it may not be desirable to extend credit because of inefficient management in the matter of payments on due dates.

2.    Trends and not the actual ratios: The different ratios calculated from the financial statements of a business enterprise for new single year are of limited value. It would be more useful to calculate the important figures in respect of income, dividends, working capital etc. for a number of years. Such trends are more useful than absolute ratios.

3.    Defective accenting information: The ratios are calculated from the accounting data in the financial statements. It means that defective information would given working ratios. Thus, the deliberate omission such as omitting purchases, would positively affect the ratios too.
4.    Change in accounting procedures: A comparison of results of two firms becomes difficult when we find that theses firms are using different procedures in respect of certain items such as inventory valuation, treatment of intangible items like goodwill, capitalization of certain expenditures like interest on the loan taken to buy an asset etc.

5.    Variations in general operating conditions: While interpreting the results based on ratio analysis, all business enterprises have to work within given general economic conditions of the industry in which the firms operate and the position of individual companies with the industry. For example, if the firm has been forced by the Government to sell its products at fixed prices, its comparison with other firms would become impossible.

6.    Ratios are sometimes misleading: Ratios must not be generally studied separately from the absolute figures, otherwise the results studied separately from the absolute figures, otherwise the results may be misleading. For example, if he output of one firm goes up from 4,000 units to 8,000 units, the ratio would show a 100% increase. On the other hand, if the second firm increases its output from 10,000 units to 15,000 units, the ratio would reflect an increase of only 50%. On the basis fo ratios, we find that first firm is more active than second though in terms of absolute figures, the contribution of second firm is more than the first.

7.    Ratios and price level changes: The changes in the level of prices may affect the comparison of figures for distant years. Assuming the level of activity to be same for two periods, say 1990 and 2000, it can be shown that the ratio of the period, say, sales to fixed assets, would be different. The reason is that the volume of sales may go up in terms of rupee value due to increase in prices in 2000 while the value of fixed assets shall be arrived at after providing depreciation from 1990 to 2000.

8.    Single ratio not sufficient: It is very necessary to take into account the combined affect of the various ratios so that the results re correctly interpreted regarding the financial condition and earning performance of the business. Each ratio plays a part in the interpretation process.

9.    The use fo standard ratios: The financial statement represent historical data and therefore the ratios based on them would only disclose what happened in the past. The utility of the ratios is increased when they are compared with budgeted or standard ratios.

10.    Ratios only a first step: Ratios are only a first step for analysis and interpretation of financial statements and must be supplemented by thorough investigation before conclusions can be drawn from them.

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