Major limitations of ratios analysis

Published: 21st January 2010
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Ratio analysis is one of the important tool to analyse financial statements, it might not inspiring for big multinational CEO's, but its significance is very much clear in front of small investors and people who have little background of finance and business. Despite the fact, ratio analysis is very significant tool for investment decisions, but still small investors fails to utilize it properly. They fail because they are not aware of the fact that, ratio analysis can do handy job for them.

But it is not necessary that ratio analysis only helps you in right directions, very often it also misleads you, so in order to protect you from any unwanted loss, you need to know about limitations of the ratio analysis. Every method has its own boundaries and limitations and ratio analysis has no exception.

These are the most crucial things to consider before using ratio analysis:

Make sure calculations are perfect:

Yes ratios are superb tool; it can convert complex data set into simplest of one or two digit outcome, which tells you the volume but, beware what if your underlying complex data is not accurate? Many complications will arrive if slightest of calculation will be mistakenly placed, because ratios are already in small numbers and slightest of variation will change complete outcome. Ratios should not be based on questionable data; make sure data is accurate and perfect.

Always use comparable data:

It is really difficult to compare two different firms, even in same sector. Of course, both have different depreciation methods, different dividend policies, different valuation methods etc. All these issues make them very difficult to compare. But even comparison of different years of same firm can be tricky. Some times companies maintain higher values of turnover while accounting position but when we look closer into ledgers we find inconsistency in posting of different transactions. So this sort of recording makes data doubtful and authenticity of ratio analysis affected badly.

Limited reflections:

Another problem while using ratios is that it only reflects outcomes from financial statements. It never shows factors that affect business scenes, due to which these numbers in financial statements are changed and some factors we can not define in accounting terms.

These are the basic limitations of ratio analysis; you must consider these before using ratios technique to take decision for any investment or any kind of financial evaluation.

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