Limitations of Ratio Analysis
Ratio analysis is one of the best tools to build a picture of the financial position of a particular firm. Different entities such as credit analyst, stock analyst and lenders can used the ratio analysis as a tool to find out the financial position of a business. Ratio analysis can be conducted by gathering information from the various parts of different financial statements. There may be certain limitations of the ratio analysis that must be kept in mind while analyzing the financial position and cash flow of the business using ratio analysis.
All the information used to conduct ratio analysis is historical in nature. However this is not necessary that historical data will prove hundred percent accurate results in future as well. However the historical data can be used for comparison for accuracy and consistency. The calculations of income statement are based on the current costs where as the calculations of some portions of the balance sheet are based on the historical cost. This difference of the timings of the cost can create problems in conducting the ratio analysis.
Another reason that may result in inaccuracy of the ratio analysis is the factor of inflation. If the rate of inflation varies within all the accounting periods that are under review this means that the various cost values won’t be comparable due to the difference of inflation. Another factor that can affect the accuracy of ratio analysis is aggregation that means the information within a financial statement regarding the line item may be recorded differently in the past resulting in the current ratio analysis in trend line does not compare to the trend line of the entire period.