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LIMITATIONS OF RATIOS | DISADVANTAGES OF USING RATIOS IN MAKING INVESTMENT DECISIONS
Ratio analysis is a scientific attempt devised by intelligent humans to reasonably predict the future outcome of investment. As true as this may be, investors still need to use ratio analysis with caution. Other fundamental factors should be allowed to play its role in the development of investments strategy and subsequently following it. Investors over the year have come to appreciate the importance good ratio analysis as part of their investment appraisal tools
In this article are some of the already identified limitations of ratios analysis.
DISADVANTAGES OF RATIOS
PROBLEM IN GETTING COMPARABLE INFORMATION
It is a known fact that ratios are useless if they are not compared with ratios from similar entity. You must compare likes to have realistic information. In practice, it is impossible to consciously find two companies that are identical in every sense.
USE OF OUTDATED INFORMATION
Historical accounting information is the primary source of data used for investment ratio analysis. This alone is enough to render every other factor useless. It is hard to make any meaningful judgment from information that is already out of date.
RATIOS ARE SUBJECTIVE
No two humans will give two exact judgments even while presented with the same information. Personal sense of judgment must be introduced and this makes it prone to having personal investment bias.
ANALYSIS CANNOT BE USED IN ISOLATION
Yes, an investment ratio analysis cannot be used in isolation. It must be combined with some other information from other sources. This makes it possible for element of wrong judgment to be introduced into the decision making variables through the introduction of information from unreliable and unverifiable source.
RATIOS ARE NOT DEFINITE
Ratio analyses are just guide and never a definite or concrete assertion. This makes it possible for wrong investment decision to be taken. Investment ratio analysis is not like mathematics and is therefore susceptible to inflows of noise.
RATIOS ARE SUBJECT TO MANIPULATION (CREATIVE ACCOUNTING, INAPPROPRIATE ACCOUNTING POLICIES)
Creative accounting and other form of manipulations like window dressing of accounts is a serious factor that affects financial statements ratio analysis. An investment analyst working on ratio analysis should bear this at the back of his or her mind.
RATIOS HAVE NO STANDARD FORM
There are no generally acceptable formats for presenting and interpreting ratios. This is in addition to the fact that ratio analyses are subjective in nature.
All the above points show that ratio analysis cannot be used in isolation and should be used with wisdom and caveat. Investing is not a pure science and like every other management science discipline deals with a lot of behavioural factors and unstable variables
Analyse carefully and wisely!