Question

Alder Tree Ltd. and Credar Ltd. use different accounting policies for inventory valuation. These variations leave a big question mark on the cross-sectional analysis and comparison of these two firms was not possible.

Identify the limitation of Ratio Analysis highlighted in the above situation. Also explain any two other limitations of Ratio Analysis apart from the one identified above.

Answer 1

The limitation highlighted in the above situation is Variations in Accounting Policies (or Lack of Uniformity/Standardisation). Different firms may adopt different accounting policies for valuing inventory (such as FIFO, LIFO, or Weighted Average). These variations make their financial metrics incomparable, rendering cross-sectional analysis and direct comparisons unreliable.

• Qualitative Factors Are Ignored: Ratio analysis is strictly restricted to quantitative financial data. It completely overlooks critical qualitative aspects of a business, such as management efficiency, workforce competence, brand reputation, customer satisfaction, and employee morale, which are vital to a firm’s long-term success.
• Based on Historical Data: Financial statements record past events and transactions. Consequently, the ratios derived from them are historical indicators rather than current or predictive reflections of a company’s performance, making them less relevant in fast-changing dynamic markets.