Limitations of accounting ratios

Accounting ratios are a very powerful tool for analysis and planning. However, they are not without their limitations.

Two principal limitations of accounting ratios are given below:

(a) 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, look for reasons in the drop and then try to find out the ways and means of rectifying the situation.

(b) 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 get a comprehensive picture.

For example, the fact that gross profit margin has dropped may cause an alarm but if it is seen that as a result of lowering prices (and thereby reducing GP margin) a massive increase in sales volume has been achieved which has led to a substantial improvement in ROE (return on equity), the alarm may be found misplaced. It is therefore important to be careful in the selection of ratios and to co-relate the signals provided by different but related ratios.

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