Despite being a useful tool in analyzing a firm’s financial performance, ratio analysis has its limitations. The first limitation is that ratio analysis overlooks the human aspect of a firm. A firm’s performance is primarily based on monetary figures; however, it is the human resource contributing to improved revenue via their work output. Secondly, ratio analysis will point a company’s management towards figures but not what caused the variation in the collected figures. Therefore, the figures will be less important during decision-making because the causes do not accompany the arithmetic values. Ratios are also complicated when it comes to a multi-department organization such as Puma. Each department will have to find the industry averages related to the specific departments. This implies that the generalization of the average organizational ratios may not be a true reflection of performance within their respective departments.
One limitation that is evident is that ratios are futuristic and do not display the current financial health. A firm might have poorly performed in the previous financial year but it is currently above the industry average with its financial figures. Therefore, the historical ratios would portray false financial health that ends up misleading management and investors in their decision-making. Lastly, the performance of a firm relies on several spectrums that include both external and internal factors. In as much as ratio analysis relates to both internal and external environment, it overlooks factors such as inflation that adjust balance sheets and external environmental determinants such as a recession (Bragg, 2021). Ratios should therefore be used in conjunction with other methods of analysis to create a comprehensive analysis system.
Reference List
Bragg, S., 2021. Limitations of ratio analysis — AccountingTools. [online] AccountingTools. Web.