Question

Discuss some problems with analysis using financial ratios. Give at least three problems or limitations and be sure to explain the issues.

Answer 1

Limitation of Financial Ratios -

1.) Financial ratios are not useful when viewed in isolation. They are only valid when compared to those of other firms or the company's historical performance.

2.) Comparisons with other companies are made more difficult because of different accounting treatments. This particularly important when analyzing non-U.S. firms.

3.) It is difficult to find comparable industry ratios when analyzing companies that operate in multiple industries.

4.) Conclusions cannot be made from viewing one set of ratios. All ratios must be viewed relative to one another.

5.) Determining the target or comparison value for a ratio is difficult, requiring some range of acceptable values.