Ratio Analysis is a very useful tool for making a comparison of information or values taken from the financial statement in order to make a judgment about the financial health of the company. such Ratio analysis is useful for both insider or outside stakeholders like credit analyst, lender, or stock analyst.
However, there are many Limitations of financial ratio analysis may include which of the following:
- Historical: Ratio analysis accomplishes on the basis of actual historical result taken from the financial statement. so no one can not say that the same result will be carried forward into the future. However, you can only use ratio analysis on pro forma information for making of comparison in between historical records.
- Inflation: inflation is such a factor which varied from time to time. if the rate of inflation has changed in the period under review, it means that all the numbers would not be comparable for the whole period.
- Historical versus current cost: are also the major limitation, because, the information provided on the income statement is expressed in current cost, however some element on the Balance sheet you will find as based on historical cost. in the end, the result will be an unusual ratio.
- Aggregation: it is not possible to make a comparison of the same information of the entire period taken from the financial statement line. because you are analyzing the value or information which may have been aggregated in the past.
- Operational changes: in some cases companies changes its operational structure, in such case ratio calculated many years ago cannot be compared today. Because this comparison will lead to a misleading conclusion.
- Accounting policies: Every company may have it’s own the policy of maintaining its recording the same accounting transaction. in simple word you can say if you are making the comparison of companies having different policies may look like the comparison in between apple and orange.
On a conclusive note, we can say that ratio analysis has a variety of limitation that damage its important. However, as long as you understand these restrictions and problems and use other methods to collect and interpret information, but keep in mind, ratio analysis important.