Ratios have limitations in analyzing business performance and financial position. Ratios are based on financial statements, so they inherit limitations such as the exclusion of certain assets from statements. Creative accounting can also mislead ratios, as companies may deliberately misrepresent financial health. Inflation distorts reported asset values and profit measurements in financial statements, hindering ratio comparisons over time. Relying only on ratios can overlook useful absolute information in statements. Differences between companies in accounting policies and other factors limit meaningful comparisons using ratios alone.

1. Finance &
Investment
1
PRESENTED BY
Dr. Ramadan Babers
https://www.linkedin.com/in/ramadan-babers-phd-78976345/
Part_10

2. 2
• Introduction
1 • Quality of financial statements
2 • Creative accounting
3 • Inflation
4 • Over-reliance on ratios
5 • The basis for comparison
Limitations of ratio analysis

3. 3Introduction
• Although ratios offer a quick
and useful method of analyzing
the position and performance
of a business, they are not
without their problems and
limitations
• We shall now review some of
their shortcomings.

4. 41- Quality of financial statements
• It must always be remembered that
ratios are based on financial
statements. They will, therefore,
inherit the limitations of the financial
statements on which they are based
• one important limitation of financial
statements is their failure to include
all resources controlled by the
business
example: goodwill and brands are
excluded because they fail to meet the
strict definition of an asset

5. 52- Creative accounting
• There is also the problem of deliberate attempts to
make the financial statements misleading
• Despite the proliferation of accounting rules and
the independent checks that are imposed, there is
evidence that the directors of some businesses
have employed particular accounting policies or
structured particular transactions in such a way as
to portray a picture of financial health that is in line
with what they would like users to see rather than
what is a true and fair view of financial position and
performance
• This practice is referred to as creative accounting
and it can pose a major problem for those seeking
to gain an impression of the financial health of a
business

6. 62- Creative accounting (cont.)
• The particular methods that unscrupulous
directors use to manipulate the financial
statements are many and varied .
• They can involve overstatement of
revenues, manipulation of expenses,
concealing losses and liabilities and
overstating asset values
• The methods used often involve the early
recognition of sales income gnitroper eht ro
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7. 72- Creative accounting (cont.)
When examining the financial statements of a business, a number of checks may be
carried out to help gain a ‘feel ’for their reliability
These can include checks to see whether:
• The reported profits are significantly higher
than the operating cash flows for the period
• The tax charge is low in relation to reported
profits
• The valuation methods used for assets held
are based on historic cost or current values
and if the latter approach has been used
why and how the current values were
determined
• There have been any changes in
accounting policies over the period and
adopted are in line with those adopted
by the rest of the industry
• The auditors ’report gives a ‘clean bill of
health ’to the financial statements
• The ‘small print’ that is, the notes to the
financial statements, is not being used to
hide significant events or changes.
Although such checks are useful, they are not guaranteed to identify creative accounting
practices, some of which may be very deeply seated

8. 83- Inflation
• the financial results of businesses can be
distorted as a result of inflation
• One effect of inflation is that the reported
value of assets held for any length of time may
bear little relation to current values. i.e. the
reported values of assets will be understated in
current terms during a period of inflation as
they are usually reported at the original cost
• This means that comparisons, either between
businesses or between periods, will be
hindered
• A difference in, say, ROCE may simply be
owing to the fact that assets shown in one of
the statements of financial position being
compared were acquired more recently
(ignoring the effect of depreciation on the
asset values)
• Another effect of inflation is to distort the
measurement of profit. In the calculation of
profit, sales revenue is often matched with
costs incurred at an earlier time (time lag)
• During a period of inflation, this will mean that
the expense does not reflect prices that are
current at the time of the sale
• The cost of sales figure is usually based on the
historic cost of the inventories concerned. As a
result, expenses will be understated in the
income statement and this, in turn, means that
profit will be overstated

9. 94- Over-reliance on ratios
• It is important not to rely exclusively on ratios,
thereby losing sight of information contained
in the underlying financial statements
• As we saw earlier in the chapter, some items
reported in these statements can be vital in
assessing position and performance
• For example, the total sales revenue, capital
employed and profit figures may be useful in
assessing changes in absolute size that occur
over time, or in assessing differences in scale
between businesses. Ratios do not provide
such information
• When comparing one figure with another,
ratios measure relative performance and
position and therefore provide only part of
the picture
• When comparing two businesses, therefore,
it will often be useful to assess the absolute
size of profits, as well as the relative
profitability of each business
• For example, Business A may generate £1
million operating profit and have a ROCE of
15 per cent and Business B may generate
£100,000 operating profit and have a ROCE
of 20 per cent
• Although Business B has a higher level of
profitability, as measured by ROCE, it
generates lower total operating profits

10. 105- The basis for comparison
• We saw earlier that if ratios are to be useful,
they require a basis for comparison
• Moreover, it is important that we compare
like with like. Where the comparison is with
another business, there can be difficulties. No
two businesses are identical: the greater the
differences between the businesses being
compared, the greater the limitations of ratio
analysis
• Furthermore, any differences in accounting
policies, financing methods (gearing levels)
and financial year ends will add to the
problems of making comparisons between
businesses

11. End
Q & A
11