Ratio analysis is a very useful technique. But one should be aware of its limitations as well. The following limitations should b& kept in mind while making use of ratio analysis in interpreting the financial statements.
1. Reliability of ratios depends upon the correctness of the basic data.
Ratios obviously are going to be only as reliable as the simple data on which they are dependent. If the balance sheet or loss and profit account figures are on their own unreliable, it is a mistake to set any reliance on the ratios worked out on the foundation of that Balance Sheet or Loss and Profit Account.
2. An individual ratio may by itself be meaningless. Except in several cases, an accounting ratio might by itself be acquires significance and meaningless only if compared with relevant ratios of other organizations or of the earlier years. In fact, ratios yield their finest advantage on comparison with other comparable firms; also if ratios for any year are compared with ratios within the previous years, it is a useful exercise. Comparison is actually the essential requirement for utilizing ratios for interpreting a given situation in a industry or firm.
3. Ratios are not always comparable. If the ratios of two companies are becoming compared, it needs to be remembered that various firms may stick to different accounting practices. For instance, one company may charge depreciation on right line basis and another on diminishing value. In the same way, different firms might adopt different strategies of stock valuation. Such variations will not make a few of the accounting ratios strictly comparable. But, use of accounting standards can make ratio comparable.
4. Ratios sometimes give a misleading picture. One company produces 500 units in one year and 1,000 units the next year; the progress is 100%. Another firm produces 4,000 units in one year and 5,000 in the ‘next year, the progress is 25%. The second firm will appear to be less active than the first firm, if only the rate of increase or ratio is compared. It will be much more useful if absolute figures are also compared along with rate of increase—unless the firms being compared are equal in all respects.
In fact, one should be extremely careful while comparing the results of one firm with those of
another firm if the two figures differ in any significant manner, say in size, location, degree of automation or mechanisation.
Ratio Analysis Formula
Ratios ignore qualitative factors. Ratios are like a matter of fact, equipment of quantitative analysis. It disregards qualitative factors that sometimes are similarly or rather more essential than the quantitative aspects. As a result of this, conclusions through ratio analysis formula might be distorted. For instance, despite the fact which credit may be given to a customer on the basis of information about the financial position of business like disclosed through certain ratios, however the grant of credit ultimately depends on the credit standing, reputation and managerial capacity of the customer, which cannot be expressed in the type of ratios.
Change in price levels makes ratio analysis formula ineffective. Adjustments in price levels usually make comparison of figures for several years difficult. For instance, the ratio of sales to set assets in 2003 will be much higher compared to 1995 due to growing prices because fixed assets remain being expressed about the basis of cost incurred several years ago while sales are getting expressed at their existing prices.
There is no single standard for comparison. Ratios of an organization have meaning only if they are compared with a few standard ratios. Circumstances vary from firm to firm and the character of each industry is various. Therefore, the standards will vary for every industry and the situations of each company will need to be kept in mind. It is hard to find out a correct basis of comparison. As a result, the efficiency of one industry may not be correctly comparable with that of another. Generally it is recommended that ratios ought to be compared with the average of the industry. However the industry averages aren't easily available.
Accounting Ratio Analysis
Ratios based on past financial statements are no indicators of future.
Accounting ratios analysis are usually calculated on the schedule of financial statements of previous years. Ratios thus show what has happened in yesteryear. Since past is very different from what will probably happen in future, it is hard to use ratios for forecasting functions. The financial analyst is much more interested in what will take place in future.
The management of an organization has information regarding the companys future plans and policies and is, therefore, capable of predict future to some certain extent. However an outsider analyst must rely only on the earlier ratios which might not necessarily reflect the company’s future financial position and efficiency.
Conclusion. On the basis of advantages and limitations of ratio analysis discussed above, it may be concluded that ratios are extremely useful if used with caution. Ratio analysis should not be performed mechanically. This may prove not only misleading but also dangerous. Limitations of ratio analysis should always be kept in mind as precautions while drawing any conclusions from the ratios.