Question

What are some potential problems and limitations of financial ratio analysis?

Answer 1

Financial ratio analysis can be very useful tool for understanding a firm's performance and condition.However, there are certain problems and limitations encountered in such analysis which call for care,circumspection and judgment.

Problems and limitations in Financial ratio analysis are as follows:

(a) Lack of an underlying theory: The basic problem in financial ratio analysis is that there is no theory that tells us which numbers to look at and how to interpret them. In the absense of an underlying theorey,financial ratio analysis appears to be ad hoc, informal and subjetive.

(b) Conglomerate Firms: Many firms have operations spanning a wide range of industries.Given the diversity of their product lines,it is difficult to find suitable benchmarks for evaluating their financial performance and condition. Hence, it appears that meaningful benchmarks may be available only for firms which have a well defined industry classification.

(c) Window Dressing: Firms may resort to window dressing to project a favourable financial picture.For example, a firm may preppare its balance sheet at a point when its inventory level is very low.As a result, it may appear that the firm has a very comfortable liquidity position and a higher turnover of inventories.

(d) Price level changes: Financial accounting does not take into account price level changes.As a result,balance sheet figures are distorted and profit misreported.Hence, the financial statement analysis can be vitiated.

(e) Variations in Accounting policies: Business firms have some latitude in the accounting treatment of items like depreciation, valuation of stocks, research and development expenses, foreign exchange transactions, installment sales, preliminary and pre-operative expenses, provision of reserves and revaluation of assets.Due to diversity of accounting policies found in practice,comparative financial ratio analysis may be vitiated.