Ratio analysis is an important tool for evaluation of a company’s performance. Performance can be measured both in financial and operational terms by using various ratios. Ratios are frequently used to make inter firm and intra firm comparisons. Ratios provide useful information to shareholders/investors who may be interested in knowing the overall profitability and solvency of the company.Ratio analysis is however not free from limitations.

Let Us Discuss Some Important Limitations Associated With Ratio Analysis.

Qualitative Versus Quantitative: 

Ratios are calculated with the help of figures available in the financial statements (profit and loss account and balance sheet). Hence, qualitative factors which are relevant to any business are completely ignored. Investors normally make their decisions based on these ratios and ignore facts like quality of management which plays a significant role in the overall functioning of any organization.

Possibility Of Manipulation/Errors:

Ratios are based on financial statement figures which can be manipulated by the management to reflect better financial status. Hence, any ratios calculated with the help of these figures will not provide correct picture as to the company’s position. Moreover, it may mislead various stakeholders by giving a false representation on the company’s performance. Further it is possible that financial statements are not correct on account of errors committed while recording transactions and preparing financial statements. In this case also, ratios will not give a true picture.

Based On Past Figures:

Ratios are calculated with figures already available, that is, on the basis of figures mentioned in the financial statements. Ratios based on past figures may not provide an accurate picture as to the future conditions and status of the company. A company may have excellent ratios for one year, but it would be difficult to say that same level of performance can be maintained in the coming years on the basis of ratios for the current year. Hence, ratio analysis is not future oriented.

Subject To Different Interpretations And Personal Bias: 

Ratios are subject to different interpretations by different analysts. To some, a particular percentage of gross profit may appear favorable while to others it may not seem to be too favorable. Hence, opinions formed on the basis of ratios may have their own limitations. Further ratios may be subject to personal bias of the person reviewing and studying the ratio which may affect the validity of the analysis so performed.

Difference In Accounting Methods/Policies Not Considered:

Ratios are used to make comparison of performance with other firms in the same industry. However, such a comparison may not give a true picture as different companies may follow different accounting methods/policies. For Instance, a company may use First in First out (FIFO) method for recording its closing inventory while another firm may use Last in First out (LIFO) method to record its closing inventory.

Price Level Changes Ignored:

Change in price level (inflation) may take place over a period of time. These changes may not get accounted for while calculating ratios making comparison difficult and inaccurate.Irrespective of the limitations outlined above, ratio analysis is considered as one of the most important financial analysis tool. It is widely used throughout the industry while recommending investment decisions.