Impact of Inflation

The second major limitation of the ratio analysis as a tool of financial analysis is associated with price level changes. This weakness of the traditional financial statements which are based on historical costs. An implication of this feature of the financial statement, as regards ratio analysis is that assets acquired at different periods are, in effect, shown at different prices in the balance sheet, as they are not adjusted for changes in the price level. As a result, ratio analysis will not yield strictly comparable and therefore, dependable results. To illustrate, there are two firms which have identical rates of returns on investments say 15 per cent. But one of these had acquired it fixed assets when prices were relatively low, while the other one had purchased them when prices Were high. As a result, the book value of the fixed assets of the former type of firm would be lower, while that of the latter higher. From the point of view of profitability, the return on the investment of the firm with a lower book value would be overstated, obviously, identical rates of returns on investment are not indicative of equal profitability of the two firms. This is a limitation of ratios.

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