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Limitations of Ratios

Accounting (Year 12) - Ratios

Christian Bien

Limitation #1: Ratios Only Indicate Areas of Underperformance, But Not the Reasons for Underperformance

Ratio analysis is only a high level indicator of a company performance; it does not show the causes of ratios. Information, such as financial reports, need to be analysed to determine the root causes of a ratio result.

For example, a company might have an improved inventory turnover suggesting of better inventory management. However, the cause of this ratio could be from increased discounts to lure customers to purchase more inventory, a sign of poor inventory management.

Limitation #2: Ability to Gather Information to Calculate Ratios is Limited by the Disclosure of a Company

Ratio analysis is only limited by the disclosure of information by companies. A Company may choose not to disclose certain information that may be necessarily to calculate a ratio.

For example, for public companies, it may be difficult to obtain the exact prepayment amount as these are often consolidated under 'current assets', resulting in an inaccurate quick asset ratio.

Limitation #3: Companies May Use Different Accounting Systems

Ratio analysis can sometimes be limited in comparability due to the different accounting structures and systems of different companies.

For example, a company may use a perpetual inventory system while another might use a periodic inventory system. Therefore, the inventory turnover analysis would be completely different and useless in comparing the two companies.

Limitation #4: Ratios Need to Compared to Industry Averages

Ratio analysis have to be compared to the industry to allow the user to obtain an overall indicator of the company’s performance relative to its peers. Ratios of a company on its own may not tell the full story.

For example, consider a Company such as Qantas. It experienced a sharp fall in its profit ratio of 2020. However, when we compare this to the industry average, the decline was experienced industry wide across all aviation companies. Therefore, it could be argued the fall in the profit ratio was due to unprofitable industry, arising from factors outside of Qantas' control.

Limitation #5: Fluctuating Share Prices Require Constant Recalculation of Market Ratios

Certain market ratios, such as price earnings ratios and dividend yields are only reliable for a short period of time due to the constant fluctuations of market share prices. Therefore, market ratios will have to be recalculated frequently to be accurate and useful.

For example, if a Company provided a dividend of $1 and had a share price of $10, the Company's dividend yield is 10%. However, we know that share prices are volatile, a sudden announcement could result in the share price rising to $20. As a result, the dividend yield falls to 5%.

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