Limitations of ratio analysis, Accounting Basics

Limitations of Ratio Analysis:  In spite of the a variety of uses of ratio analysis, it go through from certain limitations, some of which are as under;

1.    Limited use of a single ratio: A single ratio does not express any meaning. Ratios are helpful only when calculated in sufficient numbers.

2.    Lack of adequate standards:  It is not easy to set ideal ratios for each firm/ industry.  And moreover setting of typical ratios for all the firms in each industry is hard.

3.    Inherent limitations of accounting: As Ratio analysis is based on financial statements, the analysis suffers from the limitations of financial statements.

4.    Change of   accounting procedure:  If different methods are followed by dissimilar firms for their evaluation, contrast will virtually be of no use.

5.    Window dressing:   Ratios based on dressed up   (manipulated) financial information are not of a lot use as they illustrate unreliable position of the firm

6.    Personal bias:   different people will understand the similar ratio in dissimilar ways. Therefore, there is always the option that interpretation of the data may be dissimilar for dissimilar people, and this in revolve may result in many inferences for the similar data, which may be confusing.

7.    Price level changes are not offered for in ratio analysis which might lead to a misleading interpretation of business operations

8.    Ignorance of qualitative factors:  Ratios are tools of quantitative analysis only and usually qualitative factors which may usually manipulate the termination, (ex - a high current ratio May not necessarily mean sound liquid position when current assets comprise a huge inventory consisting typically of out of date items) are unseen while they are planned.

Posted Date: 10/15/2012 5:56:40 AM | Location : United States

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