The limitations of using ratio analysis to evaluate a firm’s performance and financial health

1. Ratios are only as good as the financial statements

• If the financial statements contain errors, are manipulated (“window dressing”), or use aggressive accounting estimates, the ratios will give a misleading picture.
• Example: Delaying expenses or recognising revenue early can make profitability and liquidity ratios look better than they really are.

2. Differences in accounting policies

• Firms may use different accounting methods (e.g. FIFO vs. weighted average, different depreciation methods, different impairment policies).
• These policy choices affect profits, assets and liabilities, making ratios across firms not perfectly comparable.
• International comparisons (IFRS vs local GAAP) make this even more problematic.

3. Historical cost and inflation

Financial statements are usually prepared on a historical cost basis. In periods of high inflation, asset values and expenses may be understated.

This can distort:

• Return on assets (ROA) – assets may be undervalued.
• Profit margins – revenues are at current prices, but expenses may be based on older, lower costs.

4. Lack of qualitative information

Ratios focus on numbers and ignore important qualitative factors, such as:

• Quality and competence of management
• Brand strength and customer loyalty
• Employee skills and morale
• Technological advantage, innovation, and R&D
• Regulatory or political risks

A company may look weak on ratios but have strong strategic prospects (or vice versa).

5. No universal “right” benchmark

A ratio on its own says very little. It must be compared with:

• Past performance (trend analysis)
• Industry averages
• Competitors

Even then, there is no clear “correct” level; judgement is needed. For example, a current ratio of 1.2 might be acceptable in a fast-moving retail business but risky in a capital-intensive industry.

6. Industry and firm differences

• Different industries have very different “normal” ratios (e.g. supermarkets vs. heavy manufacturing vs. banks).
• Even within an industry, firms may have different business models (online vs physical stores) that make direct comparison difficult.
• Using industry averages blindly may lead to wrong conclusions.

7. Short-term, static view

• Ratios are usually based on year-end figures; they provide a snapshot at one point in time.
• They may not reflect seasonal variations or intra-year fluctuations in sales, inventory and cash.
• A firm may look liquid at year-end because it reduced payables just before the reporting date.

8. Past performance may not predict the future

Ratios are backward-looking, based on historical data.

They may not capture:

• Upcoming new products or contracts
• Changes in technology or consumer preferences
• Future economic downturns or interest rate changes

A company with strong past ratios could still face serious future problems.

9. Difficulty in interpreting composite effects

One ratio can improve while another worsens. For example:

Profit margin falls but asset turnover rises → what happens to ROA overall?

Ratios are inter-related; focusing on a single ratio without understanding its relationship to others can be misleading.

Different analysts may interpret the same set of ratios differently.

10. Impact of one-off or exceptional items

• Non-recurring items (e.g. gain on disposal of a building, restructuring expenses, impairment losses) can significantly affect profitability ratios.
• If these are not adjusted out, the ratios may not reflect the firm’s underlying, sustainable performance.

11. Ignoring cash flow reality

• Many commonly used ratios are based on accrual accounting, not actual cash flow (e.g. profit margin, ROA, ROE).
• A company may show profit but have poor cash flow, which is more critical for survival.
• Without analysing cash flow ratios (operating cash flow to debt, interest coverage using cash, etc.), the picture is incomplete.

12. Different definitions and calculations

• There is no single standard formula for some ratios (e.g. some use average total assets, others use closing balance; some use EBIT, some use net profit).
• If the definition is not consistent, comparison across firms or across time may be invalid.

13. Conglomerates / diversified companies

• For companies operating in very different industries (conglomerates), industry averages become less meaningful.
• Group-level ratios may hide serious problems in a particular division or segment.

14. Possibility of ratio “management”

Management may take decisions mainly to improve ratios rather than to create real economic value, such as:

• Cutting R&D or marketing to boost short-term profit margins
• Selling assets to improve ROA
• Delaying necessary maintenance to reduce expenses

This can harm long-term performance even if the ratios look better in the short run.

In short

While ratio analysis is a useful starting point for evaluating performance and financial health, it has significant limitations. 

1. Ratios depend on the quality and comparability of the underlying financial statements, are affected by accounting policies, inflation and one-off items, and provide only a historical and quantitative view. 
2. They must therefore be interpreted with caution, in conjunction with other information such as cash flow analysis, qualitative assessments of management and strategy, and the broader economic and industry context.