Answer to Question #233361 in Economics for Sammy

Question

Explain 5 limitations of using ratio analysis as a means of assessing the bank’s performance.

Answer 1

While ratios are very important tools of financial analysis, they have some limitations, such as:

• The firm can make some year-end changes to their financial statements, to improve their ratios. Then the ratios end up being nothing but window dressing.
• Ratios ignore the price level changes due to inflation. Many ratios are calculated using historical costs, and they overlook the changes in price level between the periods. This does not reflect the correct financial situation.
• Accounting ratios completely ignore the qualitative aspects of the firm. They only take into consideration the monetary aspects (quantitative)
• There are no standard definitions of the ratios. So firms may be using different formulas for the ratios. One such example is Current Ratio, where some firms take into consideration all current liabilities but others ignore bank overdrafts from current liabilities while calculating current ratio
• And finally, accounting ratios do not resolve any financial problems of the company. They are a means to the end, not the actual solution.