Accounting ratio are used to measure the efficiency and profitability of the company based on its financial reports. They provide a way of expressing relationship between one accounting data point to another, and are the basis of ratio analysis.
The following are limitation of accounting ratios in appraising financial performance:
- Inconsistent definition of ratios
- Financial statements may be deliberately manipulated (creative accounting)
- Different companies may adapt different accounting policies (e.g the use of historical cost compared to current values)
- The presence of different managerial policies (e.g different companies may offer customers different payment terms)
- Statement of financial position figures may not be representative of average values throughout the year (this can be caused by seasonal trading or large acquisition of non current asset near the year end)
- The impact of price changes over time (distortion caused by inflation) are not reflected in ratios.