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Limitations of Ratio Analysis?

Though Ratio analysis is a powerful tool for analyzing the financing position of a firm, it suffers from the following limitations.

a) As ratios are calculated based on the historical data or past performance, they may not necessarily  provide the correct information that is useful in decision-making.

b) As there are no particular standards or rules of thumb for all the ratios, it is difficult to interpret accurate results.

c) In order to draw correct interpretations, a single ratio may not be helpful.  For this purpose, a number of ratios are to be calculates which is likely to confuse the financial analyst than to help him in making any meaningful conclusions.

d) Changes in the accounting procedures by the firms may mislead the ratio analysis. For example, a change in the methods of valuation inventory from FIFO(First In First Out) to LIFO(Last In Last Out) increases the cost of sales and decreases the value of closing stock. This results in unfavorable Stock Turnover Ratio and Gross Profit Ratio.

e) In Inflationary conditions, the accounting data of several years cannot be compared and therefore analysis based on such data is not accurate.

f) As Ratio analysis is purely quantitative in nature, other aspects such as managerial efficiency, employee performance cannot be interpreted.

g) Comparison of ratios of one firm to the other in an industry is not possible due to their differences in sizes, accounting procedures etc.

h) As changes in price is not considered while calculating ratios, this may adversely affect the interpretations.

What is Ratio Analysis? Different types of Ratios?


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