The following limitations are inherent in the use of ratios: -
1. Historical information. Ratios are computed from past statements thus giving historical information which may be irrelevant for future decision making.
2. Size and diversification of firms. Different firms are the same industries have different sizes, levels of technology and diversification. Thus it may not be possible to compare such firms, using ratios e.g. companion of Coca-Cola ltd and Softa ltd, Unilever and Bidco, Barclays Bank ltd and Equity Bank etc may not be possible.
3. Effects of inflation. Ratios ignore effects of inflation on the performance of a firm e.g. increase in sales may be due to increase in selling prices as a result of inflation.
4. Different accounting policies. Different firms in the same industry use different policies and bases. Accounting basis are broad methodologies used by accountants in preparation of financial statements. Policies are the particular bases adopted and constantly applied by a firm. These policies affect gross profits; net profit, etc. e.g. the use of FIFO vis-à-vis LIFO stock valuation methods, straight line vis-à-vis reducing balance methods of deprecation; etc.
5. Qualitative aspects of a firm. Ratios only capture quantitative and monetary activities of a firm and ignore important qualitative features of the firm e.g. customer satisfaction, quality of goods and services, efficiency of management, technological innovations, etc.
6. Monopolistic firms. It may be possible to carry out cross sectional and industrial analysis for monopolistic firms since they do not have competitors’ e.g. most state corporations.
7. Changes in ratios. Ratios are computed only at one point in time but they keep on changing frequently e.g. liquidity ratios will change as the level of cash, debtors and stock change.
Judiesiz answered the question on May 22, 2018 at 12:40
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March 21, 2018
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Answers (1)