Page 35 - DBP5043

LIMITATION OF FINANCIAL RATIO

1. Comparison with industry averages is difficult for conglomerates.
If a firm in various kinds of businesses or has many divisions in
different industries, its industry category is often difficult to
identify.

2. Average performance as shown in the industry average may not
be desirable. It could be better for a firm to make comparison
with market leader.

3. Seasonal factors can also distort ratios. Year-end values may not
be representative. Certain account balances may increase or
decrease. Sales are usually higher during festive due to seasonal
factor. Such changes may distort the value of the ratio before and
after such seasons significantly different.

4. Inflation distorts the firm’s financial statement. It will cause the
recorded value to be different from true value.

5. It is sometime difficult to conclude whether a ratio is good or bad.
For example a high liquidity ratio may indicate that a company is
financially sound therefore efficient in the firm’s working capital
management. High liquidity ratios may indicate overstocking and
difficulty in collecting account receivable on time

6. It is also difficult to conclude whether a firms overall performance
is good or bad. This is because most ratios by themselves are not
highly meaningful. For example some ratios may be good while
others are bad.