Ratio analysis is used to determine whether the company moves in the right direction by comparing cash flows and other financial results of the company to the ones of the previous period. It can show the company whether it achieves its goals and operates in an effective way.
However, there are many limitations that can prevent the person who is reviewing trends and results of the company from getting a clear picture of the company’s financial position. One of the factors that affect the accuracy of ratio analysis is inflation. It is an inevitable process of a growing economy, and all companies face it when operating on the market (accountingtools.com). Due to inflation, financial results cannot be compared with complete accuracy to the preceding results. Another factor can be the change in the company’s operational structure, or in the structure of its investments. Thus, ratio analysis will give the numbers that will not explain why the figures have changed, and in case they have dropped, someone can make a wrong conclusion that the company is losing money.
Also, business environment can play a significant impact on the ratio analysis, as at the times of an economic downturn, the company will probably get less income that was previously estimated. Therefore, business environment should be taken into account when reviewing financial results of the company.
There are many other factors that impose limitation on the accuracy of ratio analysis. This is why financial analysts have to pay the utmost attention to all the factors and conclusion should be made after all factors are taken into account. For example, when calculating profitability and comparing it to the previous period, current figures should be divided by inflation of the current period. So, the basic rule that can be used to handle limitations is comparing all internal and external factors that influenced the financial results, and remember about them when comparing to the financial results of the preceding period.
References
What are the limitations of ratio analysis? - Questions & Answers - AccountingTools. (n.d.). Retrieved July 10, 2015.
