Q.State the limitations of Ratio Analysis.

Because ratios are built entirely from financial-statement figures, every general limitation of financial statement analysis carries over, plus one limitation specific to ratios themselves.

Ratio analysis is based on historical costs and ignores price-level changes and qualitative factors, and can be distorted by differing accounting policies or window-dressing — the same limitations as financial statement analysis generally. In addition, a single ratio viewed in isolation, without comparing it to a past trend, an industry standard, or another firm, has very limited meaning on its own.

Ratio Analysis has all of the limitations already studied for financial statement analysis generally, plus limitations specific to ratios themselves:

1. Historical-cost basis — ratios are computed from figures recorded at historical cost, so they do not reflect the effect of price-level (inflation) changes.
2. Ignores qualitative factors — a ratio cannot capture management quality, employee morale, or brand reputation, all of which matter to a firm's real financial health.
3. Affected by differing accounting policies — a difference in depreciation method or inventory valuation between two firms (or between years) can distort a ratio-based comparison.
4. Risk of window-dressing — a deliberately favourable presentation of figures can produce a misleadingly attractive ratio.
5. A single ratio has limited meaning in isolation — a Current Ratio of, say, 2:1 tells little on its own unless compared against the firm's own past ratios, an industry benchmark, or a competitor's ratio.
6. Based on year-end figures — a ratio computed from a single Balance Sheet date may not represent the firm's position throughout the rest of the year, especially for a seasonal business whose current assets and liabilities fluctuate considerably.

Students often forget to mention the LIMITED-MEANING-WITHOUT-A-BENCHMARK point, which is the limitation most specific to ratio analysis itself (as opposed to financial statement analysis generally) — always include it, since it is frequently the specific point an examiner is looking for in a ratio-analysis limitations question.