Limitations of Ratios

Understanding Ratios

Ratios are a widely used financial tool to analyse and compare the financial health of businesses.
This handy tool acts as warning signals and enables analysts to spot trends.
Ratios can help identify areas where the company is performing well and where there are opportunities for improvement.

Limitations of Ratios

Not a Substitute for Judgement: Patients can provide early warning signs of potential issues but they are not a substitute for judgement. Management must interpret what the indicators point out.
Different Accounting Policies: Different businesses have different accounting policies, which can make it difficult to compare these businesses using ratio analysis.
Historical Information: Ratios are based on the information in the financial statements, which is historical. Therefore, they may not indicate future trends.
Non-Monetary Factors: Ratios cannot consider non-monetary factors such as the quality of the product, customer service, and employee morale.
Inflation Effects: Ratios do not account for the impact of inflation. Therefore, the comparison of ratios over different time spans may lead to distorted outcomes.

Key Considerations

While using ratios, always consider the industry norms and the benchmark ratios of competitors.
Remember, no single ratio gives a complete picture so always analyse a set of ratios.
Be aware that ratio analysis is just a starting point for further in-depth analysis of a business’ performance.