Financial ratio analysis is not only a popular method of financial statement analysis, but an effective one. It can help reveal vital information about a business, such as accounting and budgetary efficiencies, ability to finance and invest in business opportunities, and generally help businesses identify internal trends and also serve as a way to benchmark against other businesses.
But there are also limitations of ratio analysis that present possible challenges to businesses who are using it. Here are some of the top limitations of ratio analysis.
• Statistics without a clearly linked cause
Financial ratio analysis is great for helping businesses understand how different areas of a business play into the overall financial makeup of a business. But by itself, ratio analysis is a set of numbers and percentages that can give great insight into how various financial parts of the business (debt, solvency, revenue, liquidity, investment potential) and how they affect the overall financial position, but ratio analysis by itself doesn’t tell anything about the why behind the numbers. It doesn’t point to any specific causation. Without understanding or identifying the cause, it can be hard to make meaningful changes.
• Incompatible accounting methods
Even if you have access to data to competitor financial statements or industry financial averages, if they’re not using the same methods or measuring the same things as your business, you have nothing to compare your data to. Financial ratio analysis is only beneficial and meaningful if the comparative data is consistent and measuring the same things in roughly the same way. Since there aren’t always standards of what’s important to measure through ratio analysis from business to business, this can limit the effectiveness of ratio analysis.
• Incorrect reporting
Another limitation of ration analysis is the idea that the data is not standardized year over year. Inflation, for instance, can cause the numbers to skew incorrectly if not adjusted. Pure data without accounting for other factors that play into the data can distort the overall effectiveness of this method of financial analysis. Another kind of incorrect data reporting would be through “window-dressing” – a company making a move that positions them to have a more favorable financial standing. An example of this is a transaction at the end of the fiscal year that essentially artificially creates a better financial statement – like not processing a huge return until the beginning of next year because that would decrease overall sales dollar amounts. This ultimately hinders creating meaningful ration analysis and true understanding of a business’s data year over year.
• Limited predictive ability
Taken at face value, ratio analysis is a way to understand the past and present financial situations occurring within a business. It does not always lead to a better understanding of the future financial position or potential.
• Only one way of gathering data and conducting analysis
One of the biggest limitations of ratio analysis is, that while it’s effective for many things, it is only way of looking at and interpreting data. Businesses benefit from a balanced financial statement analysis that allows for a combination of perspectives that can give the organization clearer picture of all of the parts that make up the whole.
Just because there are limitations to ratio analysis as a method of financial analysis, it doesn’t mean that you should completely forego it in your financial management process. Depending on the goals of your business, it’s a perfectly useful tool for helping businesses to track trends and financial relationships within an organization. The best use of ratio analysis is when businesses utilize it as a tool that’s part of a balanced and diverse financial management system.