Limitations of Ratio Analysis

Limitations of Ratio Analysis

1. Difficult to tell if ratio is good/bad

2. Restricted to information included in financial statements only

3. Looks at past information

   • Lead time taken to produce accounts
   • Illustrates past can't be used to predict

4. Ratios only reflect the financial statement on which they are based

   • Trends and relationships must be carefully evaluated with reference to industry norms, budgets and strategic decisions

5. Doesn't include other qualitative aspects which cause success such as company relations; branding; organisation culture; skill-set of workforce

6. Comparability is hampered

   • In a conglomerate firms with lots of different divisions
   • When accounting policies are not uniform across an industry

7. Sometimes it is hard to tell if a ratio is good or bad

   • For example an increase in gearing may not be favourable as it indicates an increase in borrowing
   • Average performance is not necessarily good - perhaps the company should aim higher
   • Different operating and accounting practices can distort comparisons

8. Seasonal Factors can distort ratios

9. Window Dressing techniques can make statements and ratios look better

10. Qualitative Factors to look at:

    • Are the firm's revenues tied to one key customer, product or supplier
    • What percentage of the firm's business is generated overseas?
    • Competition
    • Future prospects
    • Legal and Regulatory environment