Q.Explain any four limitations of Ratio Analysis.

Because ratios are built entirely from the accounting figures, every weakness of those figures carries straight into the ratios drawn from them.

Four limitations are: they are based on historical cost and ignore price-level changes; they ignore qualitative factors like management quality; they can be distorted by differing accounting policies or by window-dressing; and a single ratio in isolation has limited meaning without a comparative benchmark.

The limitations of Ratio Analysis include (any four):

1. Based on historical cost - ratios use figures recorded at historical cost and so ignore the effect of price-level (inflation) changes, which can distort year-to-year comparison.
2. Ignores qualitative factors - a ratio cannot capture management quality, employee morale, or brand reputation, all of which affect real financial health.
3. Affected by differing accounting policies - differences in depreciation method or inventory valuation between firms (or between years) make ratio comparison unreliable.
4. Window-dressing - figures deliberately presented favourably (e.g. paying off creditors just before year-end) produce misleadingly attractive ratios.
5. A single ratio has limited meaning - a Current Ratio of 2 : 1, for instance, means little unless compared with the firm's own past, an industry standard, or a competitor.
6. Based on year-end figures - a ratio from one Balance Sheet date may not represent the whole year, particularly for a seasonal business.

The point most specific to ratio analysis - that a SINGLE ratio has little meaning without a benchmark for comparison - is the one students most often omit; always include it, as examiners frequently look for exactly that point.