Difficulty in Comparison
One serious limitation of ratio analysis arises out of the difficulty associated with their comparability. One technique that is employed is inter-firm comparison. But such comparisons are vitiated by different procedures adopted by various firms. The differences may relate to:
• Differences in the inventory valuation (e.g. last in first out, first in first out average cost and cost):
• Different depreciation methods (e.g. straight line vs written down basis);
• Estimated working life of assets particularly of plant and equipment:
• Amortization of imaginably assets like goodwill, patents and so on;
• Amortization of deferred revenue expenditure such as preliminary expenditure and discount on issue of shares;
• Capitalization of lease;
• Treatment of extraordinary items of income and expenditure and so on.
Secondly, apart from different accounting procedures, companies may have different accounting periods, implying differences in the composition of the assets, particularly current assets. For these reasons the ratios of two firms may not be strictly comparable.
Another basis of comparison is the industry average. This presupposes the availability, on a comprehensive scale, of various ratios for each industry group over a period of time. If, however, as is likely, such information is not compiled and available the utility of ratio analysis would be limited.