Solution 17.1

The limitations of ratio analysis are:

1. Accounting statements present a limited picture only of a business. The information included in the accounts does not cover all aspects of a business. For example human assets and inherent goodwill are excluded from the accounts.

2. Changes in a company’s accounting policies and estimates can significantly distort any inter-firm comparisons and trend analysis.

3. Ratios are based upon past performance and hence historical data. Although they can indicate future trends there is no guarantee these forecasts will be correct.

4. Ratios can be misleading if used in isolation. It is important to use comparisons with past performance or a similar company in the same business sector. Any comparison must take into account changing economic conditions and the risk factors of the particular business.

5. Inflation and its effects can be ignored.

6. The key financial indicators do not highlight whether a company is over-dependant on one customer or one product line or one supplier. Other factors that increase the commercial/business risk associated with a company may also be missed.

7. Ratios are based on the figures in the financial accounts, which contain estimates with regard to items such as provisions, revaluation’s, contingencies etc. Should any of these estimates be significantly incorrect the ratios will be misleading.