Discuss the limitations of ratio analysis and the cautions which must

Discuss the limitations of ratio analysis and the cautions which must be taken when reviewing a cross-sectional and time-series analysis.

What will be an ideal response?

ANSWER

In summarizing a large number of ratios, all aspects of a firm’s activities can be assessed. However, limitations of ratio analysis must be recognized. A comparison of current and past ratios may reveal mismanagement. But, the ratio does not give definitive cause to the problem. Additional investigation is necessary to confirm the possible problem. The analyst must be cautious of the following points: (1 ) a single ratio does not provide sufficient information to judge the overall performance of the firm, (2 ) the dates of the financial statements should be the same, (3 ) audited statements should be used, (4 ) similar accounting treatment of comparative data is essential, and (5 ) inflation and differing asset ages can distort ratio comparisons.