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Limitation of Ratio Analysis

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Every analysis has certain specific backlogs which are why it cannot be used at every place. In case of ratio analysis as well, there are certain aspects that make it fall back in dealing with specific cases.

Some of these are:

  • Limits regarding Financial Statements:

A financial statement is prepared by taking into account monetary details of the past year and summarising details and placing them in a ratio format. However, what is to be noted is that these statements have certain limitations due to certain unaccounted data. Naturally, while preparing ratios as well, these limitations are evident and thereby create a backlog for analysing ratios.

  • Problems associated with differences in price level:

For every business organisation to function in an ideal manner, it is important that there be a certain rate of inflation on-going in the market. However, when ratios based on financial statements are prepared, it can be seen that they do not depict this change of price level.

Naturally, while dealing with certain business decisions, these price fluctuations are of prime importance and hence ratio analysis cannot be used.

  • Separate formulas are followed in different cases:

Ratio analysis is specifically a quantitative tool, and there are certain qualitative aspects that are involved in ensuring that a company reaches a certain position. However, it is to be noted that different companies have different formulas for computing ratios and hence while dealing with such ratios a correct analysis regarding different companies standing cannot be measured.

  • Chances of manipulation:

For a business, sales are not the same always. In cases of disruptive sales, chances of discrepancy arise. In such a scenario, it may so happen that in place of average inventories, inventory turnover ratio is used for deciding on certain important business aspects. Naturally, there will be a massive distortion of facts and figures that will result in a bad financial decision for any company.

Hence, this manipulation that can happen at any time period and it can result in a loss for that company.

  • Personal opinion is of utmost importance:

A proper business decision is the one that is taken after a proper SWOT analysis. In such a regard, ratio analysis is merely a part of it but does not complete it. Hence, decisions can be taken on the basis of details placed in ratio analysis, but it cannot be taken as the ultimate benchmark.

Every mathematical representation has certain limitations and it is best that best aspects be taken up in regards to calculation associated with any business organisation. For a student, it is important to understand these limits that would help in ensuring better calculations. It is courtesy of its plus points that ratio analysis is still one of the most important tools for understanding position of a business.

 

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