Limitations of Ratio Analysis for Cross-Sectional Comparisons
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Ratio analysis is a useful technique for comparing a company’s performance and position with other companies. However, such comparisons may be misleading. Some of the limitations of ratio analysis for cross-sectional comparisons are discussed below: Accounting policies: Accounting laws allow companies to choose accounting policies and use discretion while preparing accounts. Such a freedom leads to differences in the accounts of companies, which in turn distorts cross-sectional company comparisons. Historic cost: If companies are of different ages, their financial statements will include non-current assets purchased at different times in the past which will usually be recorded at historic cost.
This will mean the different companies have different book values of asset, thereby affecting their financial statements even if the businesses are otherwise identical (Ireland and Leiwy, 2011). Creative accounting: Companies tend to present inflated revenues and reduced liabilities on the financial statements. In particular, they tend to window dress during earnings results seasons.
These tricks make investors believe that companies have a strong financial position. However, such creative accounting misleads analysts using financial accounting and ratios for cross-sectional comparisons. Different risk profiles: Companies have different financial and market risk profiles. Companies in the same industry may face different financial and market risks. For example, a company with a low debt ratio may indicate improved financial position. However, banks may not have provided loans to the company owing to the company’s low creditworthiness or high financial risk profiling.
Another company in the same industry may have a low financial risk profiling, and it may obtain loans at a reduced rate for expansions. But, the financial statement will only show a high gearing rate. In this case, ratio analysis leads to incorrect interpretations and conclusions about both the companies. Qualitative factors: Ratio analysis does not consider qualitative factors such as management quality, quality of assets, social responsibilities, goodwill etc.
Despite the limitations discussed above, financial ratio analysis is still useful in assessing a company’s financial performance. Ratios can provide a functional understanding of a company’s operations if used intelligently. Analysts need to understand the limitations in the analytical method and
make the necessary modifications.