Accounting ratios are powerful tools in analysis and planning. However, they are not without their limitations. Two principal limitations of accounting ratios are given below: 1. An accounting ratio is only an indicator of a problem; it is not a solution to a problem For example, a poor gross profit ratio shows that there is a problem; it does not provide an answer as to what can be done to rectify the situation. Good management effort is needed to heed the signal provided by the ratio, to look for reasons in the drop, and then try to find out the ways and means of rectifying the situation. 2. Any one ratio can paint a misleading picture It is always necessary and wise to take a group, or cluster, of ratios when analyzing financial statements in order to establish a comprehensive picture. For example, the fact that gross profit margin has dropped may cause alarm in some businesses. However, if it is noticed that as a result of lowering prices (and thereby reducing the gross profit margin), a massive increase in sales volume occurred, which substantially improved return on equity (ROE), the alarm is clearly misplaced. Therefore, it is important to be careful when selecting ratios and correlating the signals provided by different but related ratios.
Limitations of Accounting Ratios FAQs
Working Capital accounts contain an element of uncertainty because they reflect estimates made by management. Therefore, Financial Statement users should be aware that the true value could vary significantly from the amount recorded in the accounts. Examples include accruals and prepayments.
Historical-Cost Accounting uses the principle that an asset's value depreciates over time, or that its worth is gradually eroded by usage. By contrast, current-Cost Accounting states that an asset's value is what it can be sold for today - its market value. Any difference between this and the original purchase price constitutes an asset's Depreciation, or loss in value since it was bought.
Income statements contain estimates and assumptions that management makes about the business environment - some of which could turn out to be wildly inaccurate. Furthermore, not all types of income are included and there is no provision for financing. For example, if a company's inventory is falsely inflated due to management fraud, the income will be overstated until the effects appear in later accounting periods.
Balance sheet accounts contain estimates and assumptions that management makes about future events - some of which could turn out to be wildly inaccurate. Furthermore, not all types of income and expense are included and there is no provision for financing or investing activities. For example, if a company's inventory is falsely inflated due to management fraud, the balance sheet will give an inflated picture until the effects appear in later accounting periods.
Income statement items are not included in the Cash Flow statement, which makes it incomplete. Furthermore, there is no provision for financing or investing activities. For example, if a company's income is overstated due to management fraud, the Cash Flow statement will understate the amount of money that went into and out of the business. It will also fail to show that a company went bankrupt.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
