Ratios

Limitations of Ratio Analysis

Does Not Identify Causes of Ratios

Ratio analysis is only an indicator of company performance; it does not show the causes of ratios. Additional financial reports are required to analyse the causes of ratios, however, this could not be enough due to limited disclosure.

 

For example, a company might have an improved inventory turnover suggesting of better inventory management. However, the cause of this ratio could be from increased discounts to lure customers to purchase more inventory, a sign of poor inventory management.

 

Limited Disclosure of Companies

Ratio analysis is only limited by the disclosure of information by companies. If companies choose not disclose some information, then certain ratios cannot be calculated.

 

For example, a company may choose to hide it capitalised interest, limiting the ability to calculate the times interest earned ratio.

 

Companies Have Different Accounting Structures

Ratio analysis can sometimes be limited in comparability due to the different accounting structures and systems of different companies.

 

For example, a company may use a perpetual inventory system while another might use a periodic inventory system. Therefore, the inventory turnover analysis would be completely different and useless in comparing the two companies.

 

Requirement of Industry Averages

Ratio analysis have to be compared to the industry to allow the user to get an overall indicator of the company’s performance. Sometimes, industry averages are not available for users.

 

For example, a company may experience a decline in its times interest earned, but if a fall is also present in the industry average, this could be a sign of overall interest rate increases on expenses that affect all businesses competing in the industry.

Fluctuating Market Share Prices

Certain market ratios, such as price earnings ratios and dividend yields are only reliable for a short period of time due to the constant fluctuations of market share prices. Therefore, market ratios will have to be recalculated quite frequently to be accurate and useful.

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