What Are the General Limitations of Ratio Analysis?

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What Are the General Limitations of Ratio Analysis?
Financial ratio analysis looks at the company's financial statements. (business accounts image by Nicemonkey from Fotolia.com)

Ratio analysis uses parts of a financial statement to compute various ratios, then, using a system known as benchmarking, compares the ratios of one company to those of another company or to the ratios for an industry. Ratio analysis is a widely used concept, but does have several limitations that must be considered before using the analysis.

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Accounting Methods

Not all firms use the same accounting methods. For example, one firm could use straight-line depreciation while another firm uses double declining balance depreciation. Depreciation is a non-cash expense, so more depreciation will decrease net income for the period, even though performance wise, the company is not losing money. Double declining balance depreciation is an accelerated depreciation method, so the first several years of asset depreciation will be greater than the straight-line method, even if it is the exact same asset. So return on asset ratio equals net income divided by total assets.

If everything between the two firms is equal, except for one asset Firm A uses straight-line depreciation and Firm B uses double declining balance depreciation, Firm A will have a better return on asset ratio because of a higher net income early in the depreciation cycle. Nothing is different between the firms, except how they depreciate assets, yet their ratios are different.

Inflation

When comparing one period to another period on a financial statement, accountants do not typically factor in inflation. Using financial ratio analysis, then, needs more in-depth analysis as the company's balance sheet will have numbers from different periods in the inflation. In addition, earnings will increase due to inflation and not performance.

Seasonal Factors

Public companies release quarterly results, as per Securities and Exchange Commission regulations. Looking at two firms' quarterly results with ratios could be affected by seasonality. Seasonality is how a company performs in specific seasons. For example, a ski shop will have higher profits in January then August. If comparing a ski shop's financial ratios in the first quarter, January to March, to a bike shop's first quarter results, expect the ski shop to provide stronger financial ratios due to seasonality.

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