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Limtations of Ratio Analysis Essays

There are some important limitations of financial ratios that analysts should be conscious of: – Many large firms operate different divisions in different industries. For these companies it is difficult to find a meaningful set of industry-average ratios. – Inflation may have badly distorted a company’s balance sheet. In this case, profits will also be affected. Thus a ratio analysis of one company over time or a comparative analysis of companies of different ages must be interpreted with judgment. Seasonal factors can also distort ratio analysis. Understanding seasonal factors that affect a business can reduce the chance of misinterpretation. For example, a retailer’s inventory may be high in the summer in preparation for the back-to-school season. As a result, the company’s accounts payable will be high and its ROA low. – Different accounting practices can distort comparisons even within the same company (leasing versus buying equipment, LIFO versus FIFO, etc. ). – It is difficult to generalize about whether a ratio is good or not.

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