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1. Limitations of Financial Statements:
Ratios are calculated from the information recorded in the financial statements. But financial statements suffer from a number of limitations and may, therefore, affect the quality of ratio analysis.
2. Historical Information:
Financial statements provide historical information. They do not reflect current conditions. Hence, it is not useful in predicting the future.
3. Different Accounting Policies:
Different accounting policies regarding valuation of inventories, charging depreciation etc. make the accounting data and accounting ratios of two firms non-comparable.
4. Lack of Standard of Comparison:
No fixed standards can be laid down for ideal ratios. For example, current ratio is said to be ideal if current assets are twice the current liabilities. But this conclusion may not be justifiable in case of those 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 or slightly more than current liabilities.
5. Quantitative Analysis:
Ratios are tools of quantitative analysis only and qualitative factors are ignored while computing the ratios. For example, a high current ratio may not necessarily mean sound liquid position when current assets include a large inventory consisting of mostly obsolete items.
6. Window-Dressing:
The term ‘window-dressing’ means presenting the financial statements in such a way to show a better position than what it actually is. If, for instance, low rate of depreciation is charged, an item of revenue expense is treated as capital expenditure etc. the position of the concern may be made to appear in the balance sheet much better than what it is. Ratios computed from such balance sheet cannot be used for scanning the financial position of the business.
7. Changes in Price Level:
Fixed assets show the position statement at cost only. Hence, it does not reflect the changes in price level. Thus, it makes comparison difficult.
8. Causal Relationship Must:
Proper care should be taken to study only such figures as have a cause-and-effect relationship; otherwise ratios will only be misleading.
9. Ratios Account for one Variable:
Since ratios account for only one variable, they cannot always give correct picture since several other variables such Government policy, economic conditions, availability of resources etc. should be kept in mind while interpreting ratios.
10. Seasonal Factors Affect Financial Data:
Proper care must be taken when interpreting accounting ratios calculated for seasonal business. For example, an umbrella company maintains high inventory during rainy season and for the rest of year its inventory level becomes 25% of the seasonal inventory level. Hence, liquidity ratios and inventory turnover ratio will give biased picture.
Lellah answered the question on November 8, 2021 at 09:25
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