Limitations Of Accounting Ratios


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Limitations Of Accounting Ratios

 

1.    Comparative study required: Ratios are useful in judging the efficiency of the business only when they are compared with the past results of the business or with the results of a similar business. However, such a comparison only provides a glimpse of the past performance and forecasts for future may not be correct since several other factors like market conditions, management policies, etc. may affect the future operations.

 

2.    Limitations of financial statements: Ratios are based only on the information which has been recorded in the financial statements which suffer from a number of limitations.

 

For example non-financial charges though important for the business are not revealed by the financial statements. If the management of the company changes, it may have adverse effect on the future profitability of the company but this cannot be judged by having a  glance at the financial statements of the company.

 

Financial statements show only historical cost but not market value

 

The comparison of one firm with another on the basis of ratio analysis without taking into account the fact of companies having different accounting policies will be misleading and meaningless.
1.    Ratios alone are not adequate : Ratios are only indicators they cannot be taken as final regarding good or bad financial position of the business Other things have also to be seen.

 

2.    Window dressing: The term window dressing means manipulations of accounts in a way so as to conceal vital facts and present the financial statements in a way to show a better position than what it actually is. On account of such a situation presence of a particular ratio may not be a definite indicator of good or bad management.

3.    Problem of price level changes: Financial analysis based on accounting ratios will give misleading results if the effects of changes in price level are not taken into account.

4.    No fixed standards: No fixed standards can be laid down for ideal ratios. For example, current ratio is generally considered to be ideal if current assets are twice the current liabilities. However, in case of these concerns which have adequate arrangements with their bankers for providing funds when they require, it may be perfectly ideal if current assets are equal to slightly more than current liabilities.

5.    Ratios are a composite of many figures: Ratios are a composite of many different figures. Some cover a time period, others are at an instant of time while still others are only averages. A balance sheet figures shows the balance of the account at one moment of one day. It certainly may not be representative of typical balance during the year. It may, therefore, be conducted that ratio analysis, if done mechanically, is not only misleading but also dangerous.


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