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What are the Limitations of Ratio Analysis?
61 Lectures 1 hours
43 Lectures 33.5 hours
What is Ratio Analysis?
Ratio analysis is a good way of comparing the conditions of a business with its peers. It helps businesses understand their own strengths and weaknesses.
Ratio analysis are basically tools to measure the various relationships between two or more financial items. It also helps businesses compare themselves with companies of scale. However, there are some drawbacks of ratio analysis that affect its efficiency.
Limitations of Ratio Analysis
There are some prominent drawbacks of ratio analysis which analysts and investors should be aware of. They are as follows −
Base of Comparison
Although ratio analysis is a good way to measure the performances of two companies, they must be from the same industry for efficient outcomes. Standards of comparison should be the same in the case of ratio analysis. Otherwise, the ratios will be rendered futile. It is hard to find a very useful standard of comparison for data from two business statements. Although the averages of the industry can be taken as a standard, the industry averages are not readily available.
Differences in Situations of Company Conditions
Two companies in an industry are always under different business conditions. There may be differences in financial health and operations that make comparison inefficient. Therefore, comparing companies that are i8nj different situations is not a proper way to calculate the ratios.
Inflation affects a business in monetary terms in three different ways. First, it is inventory profit in which the value of inventory goes up due to inflation. In such circumstances, a company will lose money in real terms if the appreciation of inventory is less than the inflation rates.
Second, the book value of inventory will be very low when inflation is at a high point. Since inventory is recorded at book value on the balance sheet, the difference between book value and real value may differ widely.
Third, the firms that borrow money are affected by inflation. In the case of high inflation, shareholders benefit at the cost of lenders. The lenders’ money will be realized less than the actual borrowing amount when inflation is high. This creates an anomaly in calculating the effect of inflation in real terms.
Change in the Definitions of Variables
There are widespread practices that have different calculations and ways of measurement of the same item, while in some other cases, the same thing is calculated differently. For example, there are many versions of what profit means. Similarly, there are various forms for defining net worth, shareholders’ equity, current assets, liabilities, etc. Having so many versions of similar terms may affect the efficiency of the calculation of the financial ratios.
Change in Financial Situations
The financial records are not the same for the same company in two different instances. The values of items presented on financial statements change from one value to another depending on the situations that are completely different from each other.
For example, trend analysis tries to resolve the issue of changes taking two years’ data, but it is static in nature. Similarly, balance sheets comparing the values of items at different instances are also static in nature. The conditions of businesses keep changing from one period to another.
However, the statements of changes are not included while calculating the financial ratios. This creates an anomaly in deciphering the real condition of a business.
Dependence on Historical Data
Although financial ratios are made for future conditions, most of the data collected to form them are taken from the past.
For example, when the debt to equity ratio is calculated, the values of debt and equity are taken from the last balance sheet. In the meanwhile, the value of present debt and equity may have changed before the estimation of the future ratio is made.
As we can see from above points, most ratios are calculated depending on the past data, although the goal of financial ratios is to provide a viewpoint of the present and future conditions.
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