Ratio Analysis

What are the Main Limitations of Ratio Analysis?

Main Limitations of Ratio Analysis:

Ratio analysis comes with a host of challenges to the analysts, and we shall find out shortly, it is not always easy to work with these ratios, however, experienced you may be in using them.

The first limitation stems from the fact that you will not be using accounting methods or policies. For instance, at one time, you will use the recognition of goodwill and not in others; there is depreciation using straight-line or reducing balance as examples of accounting policies. All these will lead to different figures in your analysis.

Ratio analysis uses what we call creative accounts.

Some accountants take advantage of loopholes in the accounting standards so that they can falsify the figures but still present them as free from flaws. By presenting the company in a favorable light, it becomes difficult to know the extent of the off-balance sheet items.

The ratio analysis tends to rely on the summarized financial data as the base. This may limit the scope of the disclosure of the financial statements. Unfortunately, the analysts have access to the summarized data which could make it harder for them to get the full information that they need.

Multiple businesses pose a problem because of the individual items in the financial items and the issue of the numerous accounting periods. This makes it even harder to analyze business since even small changes in the gross profit margin, for instance, affect the business.

There are no two businesses that have the same risk profile; some business is more risk-averse than others. As such, it becomes hard to allocate a portfolio for the investment of an asset. Many companies have different capital, customer profile, business risk, etc hence making it difficult to use the ratio analysis for decision making.

Window dressing is malpractice in Ratio Analysis

Window dressing is malpractice, where the figures in financial statements are manipulated so that they can look impressive in the eyes of investors. If an analyst relies on such data, then they will mislead many people who are dependent on such data for investment among others.

Sometimes one is not sure when it would be most appropriate to time the transaction. For instance, a transaction that starts this year but is paid the following year would present a challenge in the entry since it has been earned but not received.

We all know that you cannot use the ratio analysis as the base for which you measure the viability of a company. There are, of course, many other factors that come into play like seasonality, different financial year-end, lack of detailed information of financial figures etc. Inflation and management issues affect the performance of a business. No matter how good analysis is, it would still be subject to the economic situations as well as the management style. All these limitations serve as reminders that even the best analysis would fail the test of time when these factors apply in some situations such as those outlined above.