Business Studies – 5.5.3 Users of accounts | e-Consult

The student's statement is incorrect. While ratio analysis is a useful tool, it's not a completely reliable way to assess a company's financial health. Ratio analysis relies on accounting data, which inherently has limitations. Here are three limitations:

• Industry Differences: Ratios are most meaningful when compared to industry averages. However, different industries have different typical ratios. A high profit margin might be excellent for a grocery store but poor for a utility company. Therefore, comparing ratios across industries can be misleading.
• Manipulation of Accounts: As mentioned before, accounting methods allow for some degree of manipulation. A company might use aggressive depreciation or overly optimistic inventory valuation to artificially improve its ratios. This can create a false impression of financial strength.
• Lack of Context: Ratios provide a snapshot but lack context. A high current ratio might seem good, but if the company has significant debt, it might still be in financial difficulty. Ratios don't tell the whole story; they need to be interpreted within the broader economic and business environment.