Building Your Business Operations & Success Accounting 6 Limitations of Using Financial Ratio Analysis By Rosemary Carlson Updated on November 30, 2022 Reviewed by Khadija Khartit Reviewed by Khadija Khartit Twitter Website Khadija Khartit is a strategy, investment, and funding expert, and an educator of fintech and strategic finance in top universities. She has been an investor, entrepreneur, and advisor for more than 25 years. She is a FINRA Series 7, 63, and 66 license holder. learn about our financial review board Fact checked by Hilarey Gould Photo: Tetra Images / Getty Images Financial ratio analysis is one of the most popular financial analysis techniques for companies and particularly small companies. Ratio analysis provides business owners with information on trends within their own company, often called trend or time-series analysis, and trends within their industry, called industry or cross-sectional analysis. Financial ratio analysis is useless without comparisons. In doing industry analysis, most businesses use benchmark companies. Benchmark companies are those considered most accurate and most important. They're used for comparison regarding industry average ratios. Companies even benchmark different divisions of their company against the same division of other benchmark companies. There are other financial analysis techniques besides ratio analysis to determine the financial health of a company. One example is a common-size financial statement analysis. These techniques fill in the gaps left by the limitations of ratio analysis, which are discussed below. Key Takeaways Financial ratio analysis is just one way to determine the financial health of a company.There are limitations to only using this technique, including balance sheets only showing historical data, companies using different accounting methods, and more.Financial ratio analysis should not be the only way you determine your company's financial health. 01 of 06 Benchmarks Are Usually Tied to Industry Averages, Not Leaders It may be contrary to everything you have ever learned. However, do you want high performance for your company? Or do you want average performance? All business owners should know the answer to that one. So benchmark your firm's financial ratios to those of high-performing firms in your industry, and you will shoot for a higher goal. However, if you use average ratios instead of the ratios of high-performance firms in your industry, you're limiting your business. 02 of 06 Balance Sheets May Be Distorted By Inflation Ever wonder why you always hear that balance sheets only show historical data? A balance sheet is a statement of a firm's financial condition at a point in time. So, looking back on a balance sheet, you see historical data. Inflation may have occurred since that data was gathered, and the figures may be distorted. Reported values on balance sheets are often different from "real" values. Inflation affects inventory values and depreciation, as well as profits. If you try to compare balance sheet information from two different time periods and inflation has played a role, there may be distortion in your ratios. 03 of 06 Ratio Analysis Gives You Numbers, But No Context You can calculate all the ratios you can find from now until doomsday. Unless you try to find the cause of the numbers you come up with, you are playing a useless game. Ratios are meaningless without comparison against trend data or industry data. Note Knowing the limitations that come with financial ratios can help you better understand them. 04 of 06 Different Divisions May Need Comparison to Different Industry Averages Very large companies may be composed of different divisions manufacturing different products or offering different services. different industry averages need to be used for each different division to make ratio analysis mean something. The ratio analysis, used in this way, will certainly be more accurate than if you tried to do a ratio analysis for this type of large company. 05 of 06 Companies Choose Different Accounting Practices Different companies may use different methods to value their inventory. If companies are compared that use different inventory valuation methods, the comparisons won't be accurate. Another issue is depreciation. Different companies use different depreciation methods. The use of different depreciation methods affects companies' financial statements differently and won't lead to valid comparisons. 06 of 06 Companies May Try To Make Financial Statements Look Better Than They Are Ratio analysis is based entirely on the data found in business firms' financial statements. Some companies may try to make those numbers look better than they are by manipulating the data in the financial statements. Bear in mind—this is completely against the concept of financial and business ethics and flies in the face of corporate governance. For example, the company may perform some transactions at the end of its fiscal year. It will impact its financial statements making them look better, but is then taken care of as soon as the new fiscal year starts. That is the simplest form of window dressing. When ratio analysis is used with knowledge and not mechanically (just cranking out the numbers), it can be a very valuable tool for financial analysis for the business owner. Its limitations have to be kept in mind, but they should be more or less intuitive to a savvy business owner. Frequently Asked Questions (FAQs) What is financial ratio analysis? Financial ratio analysis uses data from financial documents like the balance sheet and statement of cash flows to assess a company's financial health. These financial ratios help business owners assess profitability, solvency, efficiency, coverage, market value, and more. What is the benchmark ratio in financial analysis? There are four benchmark categories of ratios—profitability, leverage, liquidity, and efficiency—and each may have its own benchmark ratio to consider. For example, a good liquidity ratio is often between 1.2 and 2. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. U.S. Small Business Administration and Ascent. "Calculate & Analyze Your Financial Ratios Turning Your Financial Statements into Powerful Tools." Center for Health Information and Analysis, Commonwealth of Massachusetts. "Interpretation of Financial Ratios." Freshbooks. "What Is a Good Liquidity Ratio?"