Question

Discuss the limitations of ratio analysis.

Answer 1

The limitations of ratio analysis are as follows:

a. Diversified product lines: Many businesses operate a large number of divisions in quite different industries. In such cases ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.

b. Seasonal factors: It may also lead to influencing financial data.

c. Differences in accounting policies and accounting standards: It can lead to data of two firms non comparable as also the accounting ratios.

d. Difficult to generalise whether a particular ratio is good or bad: For example a low current ratio may be bad from the point of view of liquidity, but a high current ratio may not be good as this may result from inefficient working capital management.

e. Giving good shape to particular ratios: The business may make some year-end adjustments. Such window dressing can change the character of financial ratios which would be there had there been no such change.

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