What Is Ratio Analysis? What Are Its Limitations?

Different Accounting Policies
The choices of accounting policies may distort inter company comparisons. Example IAS 16 allows valuation of assets to be based on either revalued amount or at depreciated historical cost. The business may opt not to revalue its asset because by doing so the depreciation charge is going to be high and will result in lower profit.
Creative accounting
The businesses apply creative accounting in trying to show the better financial performance or position which can be misleading to the users of financial accounting. Like the IAS 16 mentioned above, requires that if an asset is revalued and there is a revaluation deficit, it has to be charged as an expense in income statement, but if it results in revaluation surplus the surplus should be credited to revaluation reserve. So in order to improve on its profitability level the company may select in its revaluation programme to revalue only those assets which will result in revaluation surplus leaving those with revaluation deficits still at depreciated historical cost.
Information problems
Ratios are not definitive measures
Ratios need to be interpreted carefully. They can provide clues to the company’s performance or financial situation. But on their own, they cannot show whether performance is good or bad.
Ratios require some quantitative information for an informed analysis to be made.
Outdated information in financial statement
The figures in a set of accounts are likely to be at least several months out of date, and so might not give a proper indication of the company’s current financial position.
Historical costs not suitable for decision making
IASB Conceptual framework recommends businesses to use historical cost of accounting. Where historical cost convention is used, asset valuations in the balance sheet could be misleading. Ratios based on this information will not be very useful for decision making.
Financial statements certain summarised information
Ratios are based on financial statements which are summaries of the accounting records. Through the summarisation some important information may be left out which could have been of relevance to the users of accounts. The ratios are based on the summarised year end information which may not be a true reflection of the overall year’s results.
Interpretation of the ratio
It is difficult to generalise about whether a particular ratio is ‘good’ or ‘bad’. For example a high current ratio may indicate a strong liquidity position, which is good or excessive cash which is bad. Similarly Non current assets turnover ratio may denote either a firm that uses its assets efficiently or one that is under capitalised and cannot afford to buy enough assets.

Accounting ratios attempt to highlight relationships between significant items in the accounts of a firm. By calculating ratios, we can assess the profitability, efficiency, and solvency of the firms. Areas of concern can be highlighted and decision-making can be improved. There are five groups of accounting ratios:

Profitability ratios relate profits to sales and assets. Liquidity ratios show the extent to which the firm can meet its financial obligations.

Efficiency ratios indicate how active a firm has been. Gearing ratios show the balance between equity and loan finance.

Shareholders or investment ratios are a measure of the return on investments.

Ratios are a useful tool of analysis but should always be used with caution.

First, we should always remember the accounting conventions and procedures by which various values were arrived at. The fact is that most accounting information lacks precision.

Second, although ratios are useful in making comparisons over time, we should bear in mind the effects of inflation and changes in both conditions and methods of calculation.

Third, when ratios are used for inter-firm comparisons we must bear in mind differences between the product mixes of firms and accounting methods used.

Fourth, ratios highlight problems, but other non-quantitative information should also be taken in to account.

However, ratios are more useful in depicting trends over time than in isolation.

Describe limitation of ratio analysis

A single ratio rarely tells enough to make a sound judgment.
Financial statements used in ratio analysis must be from similar points in time.
Audited financial statements are more reliable than unaudited statements.
The financial data used to compute ratios  must be developed in the same manner.
Inflation can distort comparisons.