Which statement is true about limitations of ratio analysis?

Which statement is true about limitations of ratio analysis?

• A. It provides a complete and flawless forecast of future performance.
• B. It ensures perfect cross-company comparability.
• C. It has limitations, such as differences in accounting bases making cross-company comparisons misleading.
• D. It never relies on historical data.

Answer: (C)

Ratio analysis is a useful tool for judging performance by comparing relationships between financial statement items, but it has limits. The strongest point is that cross-company comparisons can be misleading because different firms may use different accounting bases and policies. For example, one company might value inventory using FIFO while another uses LIFO, and depreciation methods or revenue recognition rules can vary. These choices change the reported figures even if real business performance is similar, so ratios can distort comparisons unless you adjust for these differences or use methods that promote comparability, like common-size statements. So the statement about limitations is true because accounting differences across firms affect what the ratios actually reflect, not because ratios provide flawless forecasts or perfect cross-company comparability. They also rely on historical data, so they don’t guarantee future results.

Ratio analysis is a useful tool for judging performance by comparing relationships between financial statement items, but it has limits. The strongest point is that cross-company comparisons can be misleading because different firms may use different accounting bases and policies. For example, one company might value inventory using FIFO while another uses LIFO, and depreciation methods or revenue recognition rules can vary. These choices change the reported figures even if real business performance is similar, so ratios can distort comparisons unless you adjust for these differences or use methods that promote comparability, like common-size statements.

So the statement about limitations is true because accounting differences across firms affect what the ratios actually reflect, not because ratios provide flawless forecasts or perfect cross-company comparability. They also rely on historical data, so they don’t guarantee future results.