Question

Critically discuss the limitations of ratio analysis.

Answer 1

In ratio analysis, ratios are calculated by making use of financial statements such as income statement and balance sheet. However, in the income statement information is presented considering current costs whereas in the balance sheet some items are based on historical costs. So, the ratios calculated on this basis of this kind of inconsistent information, the ratio analysis fails to generate meaningful analysis.

there is constant influence of the inflation on the figures of financial statements. Ratio analysis completely ignores the changes in price level due to inflation. without considering price level changes, the comparison of ratios across different periods is not meaningless.

there are several operating changes which are undertaken by the business organisation at the regular interval of time. Ratio analysis fails to consider as such qualitative aspects and merely works on the quantitative aspects.

In spite of its wide usage, there is a lack of universal guidance of its measurement and standardization. It is applied differently by different organizations. (with major or minor changes in their calculations and their interpretation)

Many times the data of financial statements are manipulated to present fair view through ratio analysis.

It is purely based on historical data and shows the past trend but there is no assurance that the same trend will continue in future too.

Lastly, it highlights the loopholes but does not provide the actual reason behind the loophole and measures to overcome those problems.