Limitations of Financial Ratio Analysis

Following are some of the limitations of Financial Ratio Analysis:

1) Ratio analysis indicates only the areas of strengths and weaknesses, without investigating the causes.

2) Different companies can apply different accounting policies. Thus the ratio of one company can not always be compared with that of another company.

3) Ratios are calculated based on outdated information presented in the financial statements. The use of historical costs may not be appropriate for decision making.

4) It may lead to distortion caused by inflation. Price level changes can make the comparison of figures difficult over a period of time.

5) Ratio analysis is mainly a technique of quantitative analysis and it ignores some important qualitative factors which can be critical in decision making.

6) Effect of window dressing by preparers of financial statements.

7) Ratio analysis is costly and small businesses may not be able to afford it.

8) There are no standard ratios. One specific ratio can have different formulas which may lead to different outcomes and difficult for comparison purposes.

9) Ratios are relative figures and do not indicate the size of a firm.

10) Lack of benchmark.

11) Accounting standards and practices in different countries vary widely, and this may hamper meaningful global-performance comparisons.

* Next: Advantages of Ratio Analysis