Requires Basis of Comparison
Financial ratios are meaningful only when compared with past performance, industry averages, or competitors. Without a proper benchmark, the ratios alone cannot provide useful insights.
Differences in Interpretation
The same ratio can be interpreted differently by different analysts. For example, a high current ratio may indicate good liquidity to one person, while another may view it as inefficient use of assets.
Differences in Situation of Two Firms
Firms may operate in different industries, scales of operation, or business environments. Comparing their ratios directly may lead to misleading conclusions, as what is considered good in one industry may be poor in another.
Change in Price Level
Ratios are based on historical accounting data. In times of inflation or deflation, book values of assets and liabilities may not reflect current market values, making ratios less reliable.
Short-Term Changes
Ratios are usually based on financial statements prepared at a specific date or period. They may reflect only short-term conditions and fail to show the long-term financial health of a firm.
No Indication of the Future
Financial ratios are based on past data. While they help in evaluating past performance, they do not guarantee future performance since market conditions, management policies, or economic factors may change.
