Which TWO of the following are valid limitations of using ratio analysis to interpret financial statements?

Answer options:

Ratios are based on historical data and may not accurately predict future performance.

Ratios eliminate the effects of inflation, making them perfectly comparable over time.

Different companies may use different accounting policies, making comparison difficult.

Ratios provide a definitive qualitative assessment of management's strategic decisions.

How to approach this question

Identify the inherent weaknesses of financial statements (historical cost, accounting choices) and how they impact ratios.

Full Answer

Ratio analysis has several limitations: 1) It is based on historical data, which may not reflect current or future realities. 2) Companies use different accounting policies (e.g., straight-line vs reducing balance depreciation), which makes comparing their ratios difficult. Ratios do not eliminate inflation, nor do they provide qualitative insights.

Common mistakes

Believing that ratios adjust for inflation or provide qualitative data.

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