Business Finance · Interpreting company accounting information

Limitations of Ratio Analysis and How to Compare Companies

Updated 11 October 2026 · Fact-checked

Ratio analysis turns accounts into comparable figures, but it relies on historical, policy-dependent numbers that can be distorted. Limits include different accounting policies, window dressing, creative accounting, inflation, year-end timing and mixed business types. To compare fairly, use trends over time, peer and industry benchmarks, consistent definitions and non-financial information.

Understand Limitations of Ratio Analysis and Comparisons

A ratio is one number divided by another. It helps you compare size-adjusted performance across years or companies. But a ratio is only as good as the accounts behind it. If the inputs are distorted, the ratio is distorted too.

The main limits come from the accounts. They show historical cost, not current value. They are a snapshot at the year end. They depend on accounting policies and estimates, such as depreciation method, inventory valuation and when revenue is recognised. Two similar companies can report different profits purely because of different choices.

Window dressing means arranging transactions near the year end so the balance sheet looks better. Examples are paying suppliers early with spare cash to lift a current ratio that is above 1, delaying payments to suppliers to show more cash, or pushing sales into the last days of the year. Which action is used depends on the figure or ratio being targeted. Delaying payments shows more cash, but it also raises current liabilities. If the current ratio is above 1, that lowers the ratio. If it is below 1, it raises the ratio. Creative accounting is wider. It uses legal choices, estimates and structuring (such as off-balance-sheet finance or aggressive revenue recognition) to flatter results. It can inflate profit, lower gearing or improve liquidity ratios. Fraud is different: it is illegal misstatement.

Inflation makes historical-cost figures hard to compare over time. Old assets look cheap, so return on capital employed looks high and asset turnover looks strong. Profits from earlier years are in money of different purchasing power. Other issues: seasonal businesses show unrepresentative year-end balances, diversified groups mix very different activities, and definitions of ratios vary between sources.

To reduce these limits, compare trends over several years, compare with peers and industry averages, check that definitions and policies match, read the notes to accounts, and add cash flow and non-financial information. A ratio raises a question. It rarely gives the final answer.

Key rules to remember

Ratio as a comparison: Ratio = Figure A ÷ Figure B; Only meaningful if A and B are measured consistently and compared with a suitable benchmark.
Current ratio: Current ratio = Current assets ÷ Current liabilities; Year-end actions such as paying creditors early or delaying payments can change it, which is why it is a common example of window dressing.
Return on capital employed: ROCE = Profit before interest and tax ÷ Capital employed; Affected by historical cost, depreciation policy and inflation.
Percentage change for trends: Change % = (This year − Last year) ÷ Last year × 100; Use to compare movements over time, not just single-year levels.

How to solve Limitations of Ratio Analysis and Comparisons questions

Use this method for any question asking you to discuss limits of ratios or to compare companies.

1Identify what is being compared: the same company over time, or different companies.
2Check the accounting basis: policies, year-end dates, currency, size and business mix.
3List the relevant limits: historical cost, policy differences, window dressing, creative accounting, inflation, seasonality, one-year snapshot.
4Link each limit to a specific ratio or figure in the question and say which direction it distorts.
5Suggest a fix: trend analysis, peer or industry benchmarks, restated figures, cash flow data, notes to accounts.
6Add non-financial information such as market conditions, management quality and strategy.
7Conclude: say what the ratios suggest, how reliable that is, and what further information you need.

Quickest way: Four-prompt checklist

When to use it: For short written or multiple-choice questions where time is tight.

Ask: Are the numbers comparable (policies, year end, size, business)?
Ask: Could the numbers be managed (window dressing, creative accounting)?
Ask: Are the numbers in real terms (inflation, historical cost)?
Ask: What benchmark is used (trend, peers, industry)? Then state one improvement.

Common mistakes in Limitations of Ratio Analysis and Comparisons

Treating window dressing and creative accounting as the same thing.
Both flatter the accounts, so they look alike.
Fix: Window dressing is year-end timing of transactions to improve the balance sheet. Creative accounting is broader use of policy choices and structuring. Neither need be fraud.
Listing limits without linking them to the ratios in the question.
Students recall a general list and stop.
Fix: Name the ratio, the limit and the direction of distortion, for example: old assets at historical cost overstate ROCE.
Saying inflation always lowers ratios.
Inflation sounds negative.
Fix: With historical cost, inflation tends to understate asset values and so can overstate returns and asset turnover. Explain the effect case by case.
Comparing with a peer without checking policies and year ends.
The ratio looks directly comparable.
Fix: State that differences in depreciation, inventory valuation, size, business mix and reporting dates can explain the gap.
Relying on one year of ratios.
Questions often give only a single set of figures.
Fix: Say a trend over several years and peer benchmarks are needed to judge whether a ratio is good or bad.

Worked examples

Example 1

A company has current assets of ₹6,00,000 (including cash ₹1,00,000) and current liabilities of ₹4,00,000. Just before the year end, it uses ₹1,00,000 of cash to pay suppliers earlier than normal. After the year end, it returns to its normal payment pattern. Explain how this could be window dressing, and calculate the current ratio before and after the early payment.

Show the solution

Current ratio before payment = 6,00,000 ÷ 4,00,000 = 1.5.
Paying ₹1,00,000 cash reduces current assets to ₹5,00,000 and current liabilities to ₹3,00,000.
Current ratio after payment = 5,00,000 ÷ 3,00,000 = 1.67 (to two decimal places).
The ratio rises because the current ratio is greater than 1: when the same amount is subtracted from both current assets and current liabilities, the ratio goes up (here from 1.5 to 1.67).
If the early payment is made only to improve the year-end figure and the company goes back to its usual payment pattern soon after, the ratio overstates normal liquidity. That is window dressing.

Answer: The current ratio rises from 1.5 to about 1.67 after the early year-end payment. If this is done only to improve the year-end figure, it is window dressing and the ratio does not reflect normal liquidity.

Exam tips

In discussion questions, link each limit to a named ratio from the data and say which way it distorts.
Always offer a remedy: trend analysis, peer benchmarks, adjusted figures or more information.
Define window dressing and creative accounting separately and give one example each.
For comparison questions, first check policies, year ends, size and business mix before interpreting the numbers.
In multiple-choice questions, watch for absolute words like 'always' or 'never' about inflation or ratios.

Practice questions from Interpreting company accounting information

Limitations of Ratio Analysis and Comparisons in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Limitations of Ratio Analysis and Comparisons: frequently asked questions

What is window dressing in accounts?

It is arranging transactions close to the year end so that the balance sheet looks stronger than normal. Examples are paying creditors early to lift a current ratio above 1, or delaying payments to show more cash. The action chosen depends on the ratio being targeted. It can mislead anyone relying on year-end ratios.

How is creative accounting different from fraud?

Creative accounting uses permitted choices, estimates or structuring to present results in a favourable way. Fraud is deliberate illegal misstatement. In exams, you may need to explain how creative accounting affects ratios without implying fraud.

How do you compare companies using financial ratios?

Check that policies, year ends, size and business type are similar. Then compare the same ratios over several years and against industry averages. Use notes to accounts and non-financial information to explain differences.

Why does inflation distort ratio analysis?

Accounts are mostly at historical cost, so figures from different dates are in money of different purchasing power. Older assets look cheap, which can overstate returns and asset turnover, and make trends hard to read.