Inadequacies of Accounting Ratios as Tools of Financial Analysis.

Ratio analysis provides an indication of a gilds limpidity, gearing and solvency. But ratios do not provide answers; they are merely a claim for management and others to the areas of a companys weaknesses and strengths (Palat 1999).

However, ratio analysis is difficult and at that place are many limitations. This section will identify and discuss the inadequacies of accounting ratios as tools of financial analysis.

ACCOUNTING POLICIES.

It is difficult to use ratios to equivalence companies, because they very often follow different accounting policies. For example, whiz company may value stock under the last in first out principle, another may follow the FIFO principle. Similarly, nonpareil company may depreciate assets under the straight line method, spell its competitors may be using reducing balance method. Also, one company may value their assets using the historical comprise rule while another may use the alternate accounting rule. Other areas in which policies may differ mingled with companies include development cost deferral policy, capitalisation of avocation costs, etc.

SKILL OF ANALYST

In other to state whether a ratio is good or bad it must be intelligently interpreted. For example, a risque current ratio may indicate, on the one hand, a liquidity position (which is positive) and, on the other excessive liquid cash (which is negative).

RETURN ON EQUITY

A direct comparison between the deliver On Equity (ROE) of different incorruptibles may not constantly be meaningful. Apart from national or industrial differences in the accounting or business practices the risk of firms may rise differ. For example, a firm with high gearing would be evaluate to earn a high ROE than would a firm with low gearing. This would be expected to earn a higher ROE than would a firm with low gearing. This will be compensated for by a higher risk precisely this is not incorporated in the ROE...

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