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  Limitations of Ratio Analysis

Introduction to Limitations of Ratio Analysis

Even though ratios present a quick and useful method of analysing the position and performance of a business, they are not without their limitations and problems. We shall now reconsider some of the shortcomings of financial ratio analysis.

Quality of financial statements

It must all the time be kept in mind that ratios are based on financial statements. So, The results of ratio analysis are dependent on the quality of these underlying statements.  Ratios will take over the limitations of the financial statements on which they are relies. As we saw earlier that one significant limitation of financial statements is their failure to involve all resources controlled through the business. Internally produced goodwill and brands, for instance, are not included from the statement of financial position since they fail to meet the strict definition of an asset. The meaning of this is that, although these resources might be of considerable value, key ratios like ROSF, ROCE and the gearing ratio will fail to acknowledge their existence.

There is also the difficulty of deliberate attempts to create the financial statements misleading.

Inflation

However, a persistent currently less severe problem in most countries is that the financial results of businesses can be distorted like a result of inflation. One influence of inflation is that the reported value of assets held for any length of time might bear slight relation to current values. Usually, the reported value of assets will be understated in current terms throughout a period of inflation because they are generally reported at their original cost (less any amounts written off for depreciation). The meaning of this is that comparisons, either among businesses or among periods, will be hindered. A variation in, say, ROCE might just be owing to the fact that assets displayed in one of the statements of financial position being compared were attained more recently (ignoring the influence of depreciation on the asset values). Other effect of inflation is to distort the measurement of profit.

Sales revenue is frequently matched with costs acquired at an earlier time in the calculation of profit. This is since there is frequently a time lag among acquiring a specific resource and using it to help produce sales revenue. For instance, inventories might well be attained various months before they are sold. Throughout a period of inflation, this will mean that the expense does not reflect prices that are present at the time of the sale. The cost of sales figure is generally relies on the historic cost of the inventories concerned. The result, expenses will be understated in the income statement and this, in turn, means that profit will be overstated. One influence of this will be to distort the profitability ratios discussed before.

The restricted view given by reliance on ratios

It is significant not to rely exclusively on ratios, thus losing sight of information consisted in the underlying financial statements. As we described earlier some items reported in these statements can be important in assessing position and performance. For instance, the total sales revenue, capital employed and profit figures might be helpful in assessing changes in absolute size that happen over time, or in assessing variations in scale among businesses. Ratios do not give such type of information.

While comparing one figure with other one, ratios measure comparative performance and position and so give only part of the picture. While comparing two businesses, so it will frequently be helpful to assess the absolute size of profits, and the relative profitability of each business. For instance, Business A might produce £1 million operating profit and have a ROCE of 15% and Business B may produce £100,000 operating profit and have a ROCE of 20%. Even though Business B has a higher level of profitability, as computed by ROCE, it produces lower total operating profits.

The basis for comparison

We consider before that if ratios are to be helpful they need a basis for comparison. Furthermore, it is significant that the analyst compares like with like. In which the comparison is with other business, there can be problems. No two businesses are similar. The greater, the variations among the businesses being compared, the greater are the limitations of ratio analysis. Additionally, any variations in accounting policies, financing methods (gearing levels) and financial year ends will add to the problems of making comparisons among businesses.

Ratios relating to the statement of financial position

Since the statement of financial position is only a 'snapshot' of the business at a specific moment in time, any ratios relies on statement of financial position figures, like the liquidity ratios, might not be representative of the financial position of the business for the year like a whole. For instance, it is general for a seasonal business to contain a financial year end that coincides along with a low point in business activity.

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