Limitations of ratio analysis

1.    The basic limitation of the technique of ratio analysis is that it may be difficult to find a basis for making the comparisons. In case of the intra-firm comparison, the performance of an organisation may vary widely from year to year. In case of the inter-firm comparison, it may become invalid due to various reasons.
(i)    The ratios of other organisations in the same industry may not be readily available.
(ii)    The constituent organisations in the same industry may vary from each other in terms of age, location, extent of automation, quality of the management and so on.
(iii)    Different accounting policies may be followed by the constituent organisations in the industry. The accounting policies may be different in the area of valuation of inventories, provision for depreciation etc.

2.    Normally, the ratios are calculated on the basis of historical financial statements. An organisation, for the purpose of proper decision making, may need the hint regarding the future happenings rather than transactions in the past. The management of the organisation may predict the future to some extent on the basis of facts and figures available to it, but the external analyst has to depend upon the past which may not necessarily reflect financial position and performance in future.

3.    The technique of ratio analysis may provide to be inadequate in some situations if there is difference of opinion regarding the interpretation of certain items while computing certain ratios. For example, in case of the computation of debt equity ratio, the opinions may differ as to the treatment of preference share capital. Some may treat this as a part of debt while the others may treat this as part of equity.

4.    As the ratios are computed on the basis of financial statements, the basis limitation which is applicable to the financial statements is equally applicable in case of the technique of ratio analysis. Also only those facts which can be expressed in financial terms are considered by the ratio analysis. For example, the computation of debt equity ratio of an organisation may show a favorable trend thereby justifying the additional borrowings which the organisation may want to make. However, if the attitude of the management is not to meet the outside obligations in time, the lender of the finance may be mislead by the computation of debt equity ratio.

5.    The technique for ratio analysis has certain limitations of use in sense that, it only highlights the strong problem areas. It does not provide any solution to rectify the problem areas. Moreover, the technique of ratio analysis may indicate the strong or problem areas. For the correct and comprehensive analysis of the situations, it is necessary to investigate further in those strong or problem areas.

6.    Ratio analysis often gives a misleading indication if the effect of changes in price levels is not taken into account. Two different years and as such, having the infrastructural facilities of different ages cannot be compared on the basis of financial statements only. This is so, as the company which has purchased the infrastructural facilities years ago may be showing their value at a very lower amount while the other company might have purchased the same facilities at a very higher price.


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