Limitations of Accounting Ratios
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.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, 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.