Limitations of ratio analysis are those characteristics of ratio analysis that acts as drawbacks when using ratios to get value added insights. Ratio analysis which is a powerful tool used by business stakeholders like management, investors, creditors, business analysts to establish useful relationship between variables has some weaknesses that makes it not to be so useful when caution is not taken.
The limitations of ratio analysis stems from some features that are inherent in the source of information that is used to calculate the ratios. This article is written to identify and explain those often overlooked factors that discredit the otherwise useful business analysis tool called ratio.
TEN (10) WEAKNESSES, LIMITATIONS AND DISADVANTAGES OF ACCOUNTING RATIO ANALYSIS
- Based on historical accounting: a classic disadvantage of financial reporting is that events are reported on historic basis. This should be borne in mind when making any investment decision.
- Transfers inefficiencies: comparing a company’s performance over the years tells you nothing when there are inherent limitations in the way things are done. Care must be taken to eliminate deficiencies in processes before applying any analysis tool.
- Does not consider the effects of inflation: inflation which is commonly defined as upward pressure on the prices of commodities are not considered when analysing a company using management accounting tool like variance analysis, ratios analysis, sensitivity analysis, balanced scorecard, etc. This disadvantage of ratio analysis can however be dealt with by basing your analysis on other forms accounting like; inflationary accounting, fair value accounting, current cost accounting, etc. The problem here is that those other methods of accounting are not free from criticism.
- Difficult to find Proxy Company: because ratios are used to compare a company with its peer, likes must be compared with likes. The drawback here is that is very difficult to find two companies that are similar in all ramifications. The best is to find a close proxy which is also a herculean task.
- Does not tell much on its own: as useful as ratio analysis is, it does not give the whole picture when viewed in isolation. This limitation of ratio analysis can be overcome by integrating other soft factors into the exercise.
- Companies can doctor their financial details: managers engage in all sorts of creative accounting and window dressing just to make a company’s financial statement look better than it should be. Ratios that are based on this financial statement will surely be misleading.
- Lack of ratio analyses knowhow: you simply cannot give what you don’t have. Financial ratio analysis will be useless if you lack the knowledge of interpreting the numbers in such a way that sound economic decision can be made.
- Does not factor in changes: ratio analyses do not consider changes that affect the business that the analyst is trying to analyse. This change can come in the form of political, economical, social, technological, environmental, and legal (PESTEL). For the whole process of financial and accounting ratio analysis to make sense, provisions have to be made to account for these macro variables.
- Does not consider non financial factors: a major criticism of ratio analysis is that it is purely based on numbers. Yes, the numbers are important but what value will be derived from numbers when it is not related to core strategic value of a company. Good accounting ratio analysis should leverage on fundamental analysis.
- Encourages suboptimal decision making: the fact that majority of ratio analysis is based on financial data makes it prone to manipulations and managers making suboptimal decisions. Part of the function of management is to ensure that motivation and incentive schemes are designed in such a way that there will be little or no room for divisional managers to indulge in any form of fraudulent act.
The aim of this post is not to dissuade you from using accounting and financial ratios in analysing and interpreting relationships that exits amongst financial variables, but to let you know that when care is not taken, limitations of ratio analysis can rubbish all the efforts that are put into generating information for managerial use.