What are some potential problems and limitations of financial ratio an

QUESTION

What are some potential problems and limitations of financial ratio analysis?
The potential limitations and problems with the financial ratio analysis are: 1. Ratios are calculated using financial accounting information which is affected by estimates and assumptions. The accounting standard permits the use of different accounting policies which affects the comparability of the ratios of different firms whose financial information is based on different accounting policies. Adoption of different accounting practices overtime by the same company also distorts the comparability of the ratios within the same company. For example if a company starts valuing its inventories on the basis of LIFO instead of FIFO the ratios become incomparable. 2. Ratio analysis assists in analyzing the past information but investors are more interested in knowing the future prospects of the firm. 3. Ratio analysis deals only in numbers. They do not consider the qualitative issues like product quality, customer service, employee morale etc. which are important¦

ors that affect the financial performance of an organization. 4. The ratio analysis is based completely on the data taken from the financial statements. If the company has made an attempt to window dress the financial statements it also affects the reliability of ratio analysis. 5. The financial statements are based on historical cost. Overtime the figures in the financial statements are distorted by inflation. Ratios based on historical data project wrong information. 6. It is difficult to generalize whether a ratio is good or not. A particular ratio may be good achievement for a small firm and may indicate poor performance for a large firm.

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