Limitations Of Ratio Analysis
The following list includes some of the more important pitfalls that may be encountered in computing and interpreting financial ratios:
- It is sometimes difficult to identify the industry category to which a firm belongs when the firm engages in multiply lines of business.
- Published industry averages are only approximations and provide the user with general guidelines rather than scientifically determined averages of the ratios of all or even a representative sample of the firms within the industry.
- Accounting practices differ widely among firms an can lead to differences in computed ratios.
- Financial ratios can be too high or too low. For example, a current ratio that falls below the norm indicates the possibility that the firm has inadequate liquidity and may at some future data be unable to pay its bills on time.
- An industry average may not provide a desirable target ratio or norm.
- Many firms experience seasonality in their operations. Thus, balance sheet entries and their corresponding ratios will vary with the time of year when the statements are prepared. To avoid this problem, an average account balancer should be used (for several months or quarter during the year) rather than the year-end total.
The analyst should be aware of these potential weaknesses when performing a ratio analysis.