Ratio analysis is a useful method for assessing the performance and financial health of a

business. However, it has its limitations one of them being a limited historical perspective. Ratio

analysis mostly uses historical financial data. Even if a company's previous performance can

reveal information about its financial health, it could not be an accurate indicator of its present or

future circumstances. For instance, a company's industry, management, or market circumstances

may have undergone considerable changes that the historical ratios do not account for. For this

reason, ratio analysis by itself might not be adequate to forecast a company's performance in the

future.

An additional limitation of ratio analysis is the lack of qualitative information. Ratios are

quantitative measurements that ignore qualitative elements like the competitiveness of the

business, strategic choices made by management, market trends, and macroeconomic conditions.

These qualitative factors are essential for gaining a thorough grasp of a company's future and

have the potential to greatly impact its financial performance. To paint a more accurate image,

ratio analysis must be combined with qualitative analysis.

Ratio analysis also lacks industry context. Ratios are most helpful when analyzed in relation to

the sector or industry in which the organization operates. In one field, a ratio that is considered

healthy could indicate trouble in another. Making insightful evaluations of a company's financial

performance is difficult if industry-specific benchmarks and standards are not taken into account.

Moreover, comparability issues also serve as limitations of financial analysis. Due to differences

in reporting standards and accounting procedures, comparing ratios between companies or

industries can be difficult. The inventory turnover ratio may be impacted, for instance, if two

businesses utilize different inventory valuation techniques, such as FIFO and LIFO. To provide a

steadier financial image, businesses may also use income-smoothing strategies, which might
skew the ratios. Analysts sometimes make subjective revisions to financial statements to

overcome this limitation and make them more comparable.

References

BBC. (2022). Purpose and limitations of Ratio Analysis - Ratios - Higher Business management

Revision. BBC Bitesize. https://www.bbc.co.uk/bitesize/guides/zrxn47h/revision/5