Ratios are basically figures that represent an element’s value in terms of the other. These are one of the most used techniques of financial analysis. Typically, ratios are used to analyse the performance or for comparison purpose. There are several characteristics of ratio analysis which make it one of the most popular financial analysis tools for newbies and professionals alike. One such characteristic is simple representation in terms of times, percentages which almost everyone among us is familiar.
Thus, even a layman is able to interpret the message behind the document which has been analysed and being read by the user of the financial statement. However, it only gives the final figure but there is no clue about the other essential details. For instance, in case of profit margin ratio for 2 companies A and B, A can have more margins than B but the sales are less for A and so is the market price per share. These things do not get accounted for the ratio.
Depending on a single ratio leads to an incomplete analysis based on half-knowledge only. It makes interpretation mechanical by limiting it to quantitative values. The context is not complete.
However, ratios are good in providing first-hand information about the performance of the company. There are also other limitations like the historical data in use, open to misinterpretation by a layman etc. Hence, ratios are mechanical and incomplete. Non-technical users require more disclosures along with ratios for a better and fair understanding of figures presented in the financial statements. Otherwise, it is subject to misinterpretation. These are some of the pitfalls of ratio analysis as a financial analysis technique.