While financial statements can present a company’s current financial health, stakeholders often desire more information from these reports. Ratio analysis represents a series of mathematical formulas a company can apply to financial statements. While these measurements do provide essential data, there are limitations of ratio analysis. A few of the most glaring limitations include potential flaws in accounting information, the need for a reference point, and the potential for ratios to be completely meaningless. Firms must overcome these flaws in order to prevent the limitations of ratio analysis from entering a company’s decision-making process.
Accounting information and data are not always flawless. While most accountants work hard to present financial information in accordance with national accounting standards, there may be some flexibility to the guidelines. This flexibility represents the starting point for limitations of ratio analysis. For example, an aggressive income recognition process can present higher profitability ratios. While this may be true for early ratios, latter ratios calculated under this income recognition process can quickly indicate lower profitability.
A reference point is also necessary to prevent the limitations of ratio analysis. For example, a company may discover certain results when calculating asset turnover ratios, such as inventory or accounts receivable turnover. Most companies use the industry standard as a reference point to determine if they are better or worse off in terms of their operating environments. When this reference point is not available, however, the company must select another. The lack of a reference point or the selection of an inappropriate reference point can skew the ratios or the use of ratios.
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Financial ratios can also be meaningless when calculated alone. These limitations exist if a company asks its accountants to compute them after preparing each financial statement. The results from each ratio, however, will not hold any meaning. In short, the results are simply additional numbers. Companies must have a well-defined purpose for calculating and using financial ratios in order for them to not be meaningless in the business.
The purpose of ratio analysis is ultimately the comparison of more than one company’s financial data for a given period. It is often difficult to make these comparisons when the financial statements are different or in alternate formats. Therefore, the ratios strip this subjectivity away and leave stakeholders with usable information so long as the limitations of ratio analysis are not present.