Name two limitations of ratio analysis in evaluating financial performance and explain why they matter.

• A. They rely on forecasts; they assume currency stability
• B. They provide cash flow insights; they show non-financial metrics
• C. They measure stock market price; they ignore debt levels
• D. They depend on accounting policies and estimates; ratios can be distorted by window dressing or one-off events

Answer: (D)

Ratio analysis hinges on the numbers reported in financial statements, and those numbers are shaped by accounting policies and estimates. Choices like which depreciation method to use, how inventory is valued, or how allowances for doubtful debts are estimated change the figures that sit behind key ratios. Because of this, ratios can reflect the accounting approach as much as the underlying performance, making comparisons over time or between different companies less reliable unless you understand the policies and any changes to them.

Two practical implications follow. First, if a company adjusts its accounting methods or revises estimates, the resulting ratio changes may not signal a real shift in performance but simply a reporting difference. This is why analysts normalize earnings or adjust for policy changes to compare true performance across periods. Second, ratios can be distorted by window dressing at year-end or by one-off events. Managers might push revenues into the period or defer expenses to improve ratios, or present a large non-recurring item as part of ongoing profitability. Such distortions paint an incomplete or misleading picture of ongoing performance, so it’s essential to check notes, adjust for non-recurring items, and corroborate with cash flow information and other non-financial indicators.