Asked in Business Accounting and BookkeepingFinancial StatementsAngel and Venture Capital
What are the potential problems and limitations of financial ratio analysis?
February 20, 2012 4:13PM
'''''Limitations of financial ratio analysis'''''
# Many ratios are calculated on the basis of the balance-sheet figures. These figures are as on the balance-sheet date only and may not be indicative of the year-round position. # Comparing the ratios with past trends and with competitors may not give a correct picture as the figures may not be easily comparable due to the difference in accounting policies, accounting period etc. # It gives current and past trends, but not future trends. # Impact of inflation is not properly reflected, as many figures are taken at historical numbers, several years old. # There are differences in approach among financial analysts on how to treat certain items, how to interpret ratios etc. # The ratios are only as good or bad as the underlying information used to calculate them.
Although ratio analysis is very important tool to judge the company's performance , following are the limitations of it.
1. Ratios are tools of quantitativeanalysis, which ignore qualitative points of view.
2. Ratios are generally distorted by inflation.
3. Ratios give false result, if they are calculated from incorrect accounting data.
4. Ratios are calculated on the basis of past data. Therefore, they do not provide complete information for future forecasting.
5. Ratios may be misleading, if they are based on false or window-dressed accounting information