Limitations of Ratio Analysis Class 12 Notes

Ratio Analysis is carried out on complex financial statements to convert them into simpler and summarised forms. As a matter of fact, the weakness in the original financial statements would also be reflected in the analysis derived from ratios.

So, ratio analysis is prone to double limitations –

1. Inherent limitation of financial statements, and
2. Limitation of ratio analysis itself.

The various limitations of ratio analysis are –

1. Default in Financial Statements – In case financial statements do not present a true and fair view of the affairs of a business, the accounting ratios derived from the financial figures would eventually be showing an untrue analysis.
2. Ignores changes – Accounting ratios ignore the concept of price level changes which lead to incorrect analysis of financial statements. Price changes are common in the inflationary economy and not taking this into account would not provide reliable results.
3. Ignores Qualitative aspects – One of the major limitations of ratio analysis is that it only takes into account financial figures, i.e. quantitative aspects. It is not concerned with the non – monetary information which also affects the performance of the company.
4. Difficult in Comparisons – Ratio analyses are popular for conducting inter and intra company comparisons. However, it does not address the issue of variation in accounting policies and procedures followed by different companies in the industry. The differences in policies could render the comparisons completely useless as it becomes difficult to compare results arrived by following different policies.
5. Unavailability of Standard Definitions – Companies tend to conduct ratio analysis with a view that the results can be compared with the ideal ratios of the industry and any deviations could then be resolved. But the problem area still remains is that there are no universally accepted levels of ideal ratios against which the performance of a company should be measured.
6. Does not offer a solution – Accounting ratios help the management in identifying the problem areas but the limitation of ratio analysis is that it does not offer a solution to the problem. This is one of the primary limitations of ratio analysis.
7. Historical Information – Ratio analysis is based on historical information provided by the financial statements. The current and future market conditions are not considered while decision making which would not yield better results.

Although ratio analysis is an indispensable tool for a company, there are quite a few limitations of ratio analysis too. It can be said that ratios are not an end rather they are the means towards the end. The management cannot completely rely on the ratio analysis as it does not take into account price changes and qualitative aspects of financial statements which are equally important for interpreting the financial statements.

Chapter  5 – Accounting Ratios

1. Objectives of Ratio Analysis
2. Advantages of Ratio Analysis
3. Limitations of Ratio Analysis
4. Types of Ratios
5. Liquidity Ratios
6. Solvency Ratios
7. Activity (or Turnover) Ratio
8. Profitability Ratios