7.10 Limitations of ratio analysis

Question 1

Ratio analysis allows business owners to identify trends and time series analysis. What are some of its limitations?

Answer 1

• simple ratios cannot represent the full picture of a company’s position
• mathematical calculation doesn’t work if the base figure is zero or negative
• ratios only give the current picture, and cannot predict future trends
• the chosen benchmark for the ratio may not always be the most appropriate
• inflation or seasonal factors may inflate ratios
• ratios are meaningless without comparison against industry data
• there may be window dressing

Question 2

What is window dressing?

Answer 2

Transactions made at year end or quarter end to improve the appearance of financial statements.