What Are Some of the Problems Associated With Using Financial Ratios? (2024)

By Chron Contributor Updated December 16, 2020

Financial ratios are used almost universally by companies of all sizes to provide numerical information on the profitability, health and direction of the business. Financial ratios provide useful analysis and can help drive management toward making better decisions if they are interpreted correctly. At face value, ratio analysis is the measure of strength and weakness of the firm, however, there are some drawbacks to relying on these metrics.

Lack of Comparability Between Companies

Financial ratios are a useful tool to track changes in business over time. For example, if a liquidity ratio is lower this year than last, there may be a problem that needs further investigation. However, ratios do a poor job at comparing one company with another, although they are often used that way.

Using ratios to compare two firms in the same industry may be difficult if, for example, a company uses a last-in-first-out valuation, its ratios that include inventory will be significantly different than a company that uses first-in-first-out. The ratios will not be comparable because the valuations are not comparable. A company's choice of accounting policies used in its financial statements will impact its ratios, according to Corporate Finance Institute.

No Indication of Cause of Changes

Ratios tell a business owner what happened but they do not tell him why it happened. Business owners must dig deeper into the numbers to determine why ratios are changing from period to period. The Accounts Receivable Turnover ratio is a good example of this, and context is key, says NetSuite.

This ratio shows how quickly accounts receivable are being collected. If the turnover slows, it means a buildup of receivables compared with sales for the period. This buildup could be caused by a number of factors, including employee inexperience, loosened credit policies or growing customer dissatisfaction with the product. A business manager needs to find the root of the problem before it can be solved.

Ratios Based on Book Value

This is one of the largest problems with relying on financial ratios. Because the financial statements are prepared based on book value (largely historical cost), they do not reflect current reality in the business. Ratios that are based on these historical numbers may not be telling the whole story about the health and direction of the company.

This is especially true for asset-based ratios. Assets may be worth more or less than the value carried on the balance sheet. If the company is in financial distress, the liquidation value of those assets will be the most relevant. A price to earnings ratio, meanwhile, may not reflect the high-growth the company is currently experiencing.

No Measurement of Management Quality

Financial ratios, like the financial statements they are based on, do not capture all of the important information that tells stakeholders how the business is doing today and helps them predict where it is going in the future. One of the key determinants of business success is the quality and experience of the management team. This information cannot be derived directly from financial ratios although large ratio swings can give an indication.

What Are Some of the Problems Associated With Using Financial Ratios? (2024)


What Are Some of the Problems Associated With Using Financial Ratios? ›

Some other limitations of financial analysis are mentioned below : The financial analysis does not contemplate cost price level changes. The financial analysis might be ambiguous without the prior knowledge of the changes in accounting procedure followed by an enterprise.

What are the disadvantages of financial ratio? ›

The limitations of financial ratios
  • No two companies are the same. No two companies are exactly alike, and that is especially so when they are operating in different industries. ...
  • Size matters. ...
  • A change in destiny. ...
  • Market sentiment and macro factors. ...
  • Risk appetite can decline. ...
  • Economic cycles can change.

What are the problems with financial analysis? ›

Some other limitations of financial analysis are mentioned below : The financial analysis does not contemplate cost price level changes. The financial analysis might be ambiguous without the prior knowledge of the changes in accounting procedure followed by an enterprise.

Why is it difficult to compare financial ratios? ›

Companies may be using different methods in accounting, which would render it difficult for the comparison of the financial ratios. The different accounting methods, assumptions made and estimates that are applied by the companies influence the information of accounting used to compute the ratios.

Why can financial ratios be misleading? ›

Key Takeaways

The P/E ratio can be misleading because it is either based on past data or projected future data (neither of which are reliable) or possibly manipulated accounting data.

What are the advantages and disadvantages of financial ratios? ›

The advantage of financial ratios is that they make the numbers on financial reports standardized and reveal aspects like profitability, solvency, leverage, and turnover. The limitations of financial ratios are that they are of past performance and may not tell the whole picture.

What are the advantages and disadvantages of using financial ratios? ›

The advantages of using ratios in analysis include providing a quick snapshot of a company's financial health. However, disadvantages include the potential for ratios to be manipulated and the need for industry-specific benchmarks. Advantage: Ratios can capture morphometric information.

What is the disadvantage of financial analysis? ›

Limitations: The analysis relies heavily on historical data and assumes that past trends will continue in the future. It does not account for external factors that can significantly impact financial performance. Additionally, it may not uncover underlying reasons for changes in financial data.

What are three financial problems? ›

Here is a list of the most common financial problems people may face: Lack of income/job loss. Unexpected expenses. Too much debt.

What are the disadvantages of financial problems? ›

They can lead to relationship problems, physical health problems and mental health issues, such as depression or anxiety. You can minimise the impact of financial stress by looking after your health and seeking support from loved ones or professionals.

What are the disadvantages of ratio analysis? ›

For example, certain firms may or may not consider current liabilities in the process of calculating their current ratio. One of the major disadvantages of ratio analysis is that it considers only the monetary inclinations of a business.

What are 5 limitations ratios? ›

Limitations of ratio analysis
  • Inflation Effects. If the rate of inflation has changed in any of the periods under review, this can mean that the numbers are not comparable across periods. ...
  • Aggregation Issues. ...
  • Operational Changes. ...
  • Accounting Policies. ...
  • Business Conditions. ...
  • Interpretation. ...
  • Company Strategy. ...
  • Point in Time.
Dec 30, 2023

How do financial ratios affect each other? ›

Financial ratios express one financial quantity concerning another and they can be used to evaluate the performance of a company over time. By reducing the effect of company size, ratios can also enhance a comparison being made between companies.

How effective are financial ratios? ›

Ratios measure the relationship between two or more components of financial statements. They are used most effectively when results over several periods are compared. This allows you to follow your company's performance over time and uncover signs of trouble.

What are 2 disadvantages of ratio analysis? ›

ratio analysis does not take into account external factors such as a worldwide recession. ratio analysis does not measure the human element of a firm. ratio analysis can only be used for comparison with other firms of the same size and type.

What are 5 disadvantages of using a financial institution? ›

Disadvantages of Financial Institutions
  • Complex and Lengthy Process. These organizations follow strict guidelines for giving loans since they must meet government standards. ...
  • Security Deposit. ...
  • Hidden Risk Involved. ...
  • Limitation on the Borrower. ...
  • Wrapping It Up.
Jan 23, 2024


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