Limitations of ratio, Finance Basics

Limitations of Ratio

Ratios have weaknesses as following like:

1. They avoid the size of the firm being compared as in cross-sectional analysis; the firm being compared might be of different product, technology and size diversification.

2. Effect of inflation: Ratio avoids the effect of inflation in performance as increase gradually in sales might be due to increase in selling price caused by inflationary pressure in the economy.

3. Ratios avoid qualitative or non-quantifiable aspects of the firm as important assets that as corporate image, customer loyalty, quality of product, efficient management team, technological innovation etc are not captured in such ratio analysis.

4. Ratios are computed only at single point in time such is they are subject to frequent changes after computation as liquidity ratios will constantly change like the debtors, cash and stock level changes.

5. Monopolistic firms : It is very difficult to carry out industrial and cross-sectional analysis to monopolistic firms while they do not have competitors and they are the just firms in the whole industry

6. Historical Data: Ratios are computed in financial statement or historical information therefore may be irrelevant in future decision-making of

7. Computation and interpretation : Usually some ratios do not have an acceptable standard of computation.  This may differ from one industry to another. Like the return on investment may be computed like as:

Return on investment =  EBIT / Total assets or EAT/ Total assets

8. Different accounting policies : Different firms in the similar industry use many accounting policies as ways of depreciation and stock valuation.  This creates comparison difficult.

Posted Date: 1/30/2013 2:25:36 AM | Location : United States







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