Limitation of RATIO Analysis explained

The term ratio means a simple division of one number by another. It is measured by the number of times one number is contained by the other, either integrally or in fraction. The ratio analysis of financial statement means the process of calculating structural relations of different items and groups in the financial statements. Generally, the ratios are classified into three broad categories viz. Structural ratios, Profitability ratios and turn over ratios. These ratios are used by analyst to evaluate significant relationships in financial statements which will be of immense use to financial analysts for making further investigation and in making final decisions. This is because; ratios provide financial analyst certain yard stick to evaluate the financial condition and performance of a firm, as ratios reduce large figures to an easily understandable relationship. Therefore, ratio analysis has gained wide acceptance as a quantitative technique of financial management. However, the ratios may not make conclusion themselves.

Example 1:  Suppose, a financial analyst reached current ratio of 2:1 from a balance sheet of manufacturing unit. According to the financial analysts, normally this ratio is most desirable for them to consider a working capital limit.  However, in reality the unit might not be in a position to pay current liabilities in time in spite of favourable current ratio. This is because of an unfavorable distribution of current assets in relation to liquidity. On the other hand, another business with a current ratio of even less than 2: 1 might not be experiencing any difficulty in making the payment of current liabilities in time because of its favourable distribution of current assets in relation to liquidity.

Example 2: In accounting parlance window dressing in the balance sheet is the technique by which financial statement is made to reveal a better picture than the actual position.  For example, showing interest on term loan as capital in the balance sheet or the temporary reduction in current liabilities by issuing cheques in payment of current liabilities and not dispatching the issued cheques to the customers or recording bogus sales value in the last few days and showing them as sales returns in the next accounting year or maximizing collection of receivables on the balance sheet date by including cheques yet to be realized etc. are examples of Window dressing (to know more click window dressing).   So the accounting ratios cannot be correct if the data (on which they are based) are not correct.

Example 3:  We know that ratio analysis is based on historical information; that is analysis is based on real past results published by the company. Here, ratio analysis metrics do not necessarily represent future company performance.

Example 4: There are many methods and techniques are used in analysis of financial statements such as ‘External Standards’ (comparison between two business concerns engaged in same line of business, with more or less same infrastructure and production capacities or Comparison can also be made with ‘Industry average’). Comparison will become difficult if the two concerns follow the different methods of providing depreciation or valuing stock or following two different standards and methods, an analysis by reference to the ratios would be misleading.

Example 5: If any lending decision is to be properly made, the risk involved in the transaction should be properly evaluated. Risk evaluation primarily consists in the ascertainment of the ability of the prospective borrower to repay the proposed loan. To ascertain this ability, apart from financial analysis many other vital considerations such as the character of the borrower, his managerial ability, technical and operational skill and the productive use to which the funds would be applied would come into operation. The computation of ratios assists analyst to evaluate only significant relationships in financial statements not on other facts mentioned above.

Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making. We have to accept that the information provided in the financial statements is not an end in itself, as no meaningful conclusions can be inferred from the analysis of statements alone. Therefore banker builds up on his own judgment by appraising   credit proposals to have a comprehensive analysis of financial statements; ratios should be used along with other methods of analysis.

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