Limitations of Ratio Analysis

Although the various types of ratio analysis are very useful to the management, there are certain inherent limitations:

1. Ratios are based upon the figures of financial statements and can be as true as the financial statement figures. In case these figures are window dressed, ratios would not be able to depict an accurate picture of the firm.

2. Another argument made against ratio analysis as a management and predictive tool is the fact that it uses past information to analyze the firm's performance. This is not properly indicative of the future and may lead to failure in predicting the future.

3. Ratio generally varies from industry-to-industry and from situation-to- situation. Various factors lead to a ratio being considered safe or unsafe; they are - the industry, the past profits of the firm, and the debt-equity mix. Thus no standard ratio can be said to be ascertainable to which all the firms should adhere to.

4. The effectiveness of studying ratio analysis is increased manifold if they are done so over a period of years. This, however, does not always happen in actual practice, and analysts are forced to state their opinion on the basis of single or a few years.

5. Different companies may follow different accounting policies in respect of depreciation, stock valuation, etc. comparison between the ratios of two firms following different policies may not give a fair picture.

6. Financial ratios are interrelated, not independent. Interpretation of ratio on its own may highlight efficiency. But interpretation of all the ratios taken together may speak differently. Such interdependence among the ratios can be taken care of through multivariate analysis.

7. It is difficult to decide the optimum level of a ratio, in spite of the presence of industry averages.

8. Many companies have operations spread across a number of industries. As there may not be any other company having a presence in the same industry, the development of a benchmark in the same proportion becomes a problem. Even when the company is not a diversified one, figures for the various firms are needed in addition to the industry average, in order to draw a meaningful conclusion.

9. Financial statement does not take into account the change in price levels. Analysis of such statements may not give a true picture of the state of affairs.   

10. There may be a high degree of correlation among the various ratios calculated, due to the presence of some common factor. This may make interpretation of all the ratios confusing. Hence, it becomes essential to choose a few ratios, which can convey the required information.

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