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The Limitations of Ratio Analysis

The Ratio Analysis framework is extensively utilized by businesses and provides companies with numerous insights into their financial operations. At the same time, Ratio Analysis has several significant limitations, which include the utilization of past data, the absence of inflation adjustments, and possible changes. First of all, every Ratio Analysis implies using previous financial data in order to make certain conclusions about the likely development of the company in the future. Yet, the problem here lies in the fact that the past data be irrelevant and therefore not predictive of the performance of the businesses in the next month, quarter, or year.

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Another limitation of Ratio Analysis is the inability to adjust the results of the analysis to the inflation, which is often unpredictable. Essentially, since companies calculate ratios based on the existing data, it becomes difficult to assess their current performance since, due to inflation, prices tend to fluctuate. For instance, inflation also affects the reported profits of the company since it impacts inventory costs and depreciation charges (Brigham & Daves, 2018). Basically, due to the fact that ratios are not calculated every week and even month, the information they offer can become completely irrelevant in a short period of time.

Finally, Ratio Analysis may also not yield the expected utility because of possible changes occurring to the business, which may be different concerning the operations or even accounting policies. In the modern economy, companies often change the goods and services they offer, as well as make adjustments in their supply chains. Every major change can directly affect the company’s performance, therefore comparing the results of the business before and after the change can lead to misleading assumptions. Moreover, companies may employ different accounting policies as part of their new Ratio Analysis. As a result, comparing the newly generated results with the old ones may cause incorrect conclusions.

Reference

Brigham, E., & Daves, P. (2018). Intermediate financial management. Cengage Learning.

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