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Limitations of Ratio Analysis

The ratio analysis is subject to certain limitations. These limitations are discussed below:

(1)    Limitations of Financial Statements

Ratio analysis is based on financial statements. The data of financial statements is the raw material for ratio analysis. This data is subject to limitations which is reflected in ratio analysis also.

(i)    Historical Costing. The financial statement are based on historical costs. Many a times, these figures are not relevant for analysis. If inflation accounting is taken into consideration, then only many of these figures become relevant. This is particularly important in Balance Sheet. In the case of fixed assets purchased throughout the life of the business, comparison is not possible. The present value of these assets are ignored; therefore, the ratio may be misleading.

(ii)    Accounting Principles. The accounting principles have no single set of rules to be followed throughout. Change in method of stock valuation, depreciation, etc., may lead to wrong conclusions.

(iii)    Lack of reliability. The financial statements give the year end figures and not the averages. These may be called rough and ready figures and are not completely reliable.

(II) Broad Indicator

The ratios do not give a full background. They are just broad indicators as shown below:

(i)    Non-consideration of qualitative factors. Ratio analysis does not take into consideration qualitative factors. The numbers by themselves are not sufficient. The liquidity position of a company may be very sound, but the management may be bad which may be lead to trouble for creditors.

(ii)    Impact of environmental factors. The environmental factors have agreat bearing on the future of any business enterprise. The company may flourish during boom period despite bad ratio indicators. Hence the factors other than ratio analysis need to be considered for a complete analysis.

(III) Comparison

The comparison is very difficult due to inconsistency in policies.
(i)    Inter-firm comparison. The inter-firm comparison is rarely possible. It is because the policies of any tow companies are not the same. Hence, comparison between incomparable is futile. It will note give a true picture and would lead to depreciation, stock valuation, taxation, etc.

(ii)    Intra-firm comparison. The comparison within the same firm with that of past years is known as intra-firm comparison. Sometimes even this comparison is not possible because of change in policies of depreciations must be made very carefully. This is the thrust area of ratio analysis despite limitations.

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