Question

Which of the following statements represent a weakness or limitation of ratio analysis? Check all that apply. A firm may operate in multiple industries. A firm’s financial statements show only one period of financial data. Different firms may use different accounting practices.

Answer 1

Answer: A firm may operate in multiple industries.

Different firms may use different accounting practices.

Explanation:

Ratio Analysis as you probably know is a very useful tool in financial analysis. It works by comparing ratios based on items in the financial statements of a company to measure certain things such as the Company's Liquidity, Profitability and the like.

It does have certain drawbacks though such as,

A firm may operate in multiple industries

When a firm is operating in multiple industries. Comparing ratios is not a simple task. Different industries record profits and costs differently and just because a ratio is held in high esteem on one company does not mean it is good in another thereby making comparison based on ratios alone quite cumbersome.

Different firms may use different accounting practices

Now if different companies use different Accounting practices, you might find that ratios cannot be straightforwardly compared because different types of figures were used by the different companies. For instance, some companies might use a Straight Line Depreciation method as opposed to a Reducing Balance method which will have varying effects on income.