abhishreshthaa
Abhijeet S
Limitations of overall profitability ratio
The overall profitability ratio suffers from certain important limitations. These are as under:
1. Manipulation Possible: the overall profitability ratio is based on earnings and investments. Both these figures can be manipulated by management by adopting varying accounting policies regarding depreciation, inventory valuation, treatment of provisions, etc… the decision in respect of most of these matters is arbitrary and subject to whims of the management.
2. Different Basis for Computation of Profits and Investments: There different bases for calculating both profits and investments. For e.g. fixed assets may be taken at gross or net values, earnings may be taken before or after tax, etc…
3. Emphasis on Short-Term Profits: The overall profitability ratio emphasises the generation of short-term profits. The firm may achieve this objective cutting down cost such as those on research and development or sales promotion. Cutting down of such cost without any justification may adversely affect the profitability of the company in the long run, though this ratio may indicate better performance in the short-run.
4. Poor Measure: The overall profitability ratio is a poor means of a firm’s performance since it is also affected by many extraneous and non-controllable factors. Often the present return is the result of the wisdom or the folly of the past management. Thus, the present management cannot take credit or be held responsible for the doing of their predecessors.
5. Undue Significance to Capital Resources: The overall profitability ratio gives undue significance to capital resources whereas profits are the result of contribution of various other inputs particularly human resources. However, their role is not clearly visible in the computation of overall profitability ratio.
6. Mars Initiative: The overall profitability ratio, when used as a measure for the evaluation of the performance of managers, may mar their initiative. Managers who are satisfied with the present ratio tend to become conservative and may not take any initiative to expand due to the fear of decrease in the profitability ratio. This would result in non-exploitation of the available opportunities and resources.
7. Chance Factor: Sometimes high or low profit may be due to chance. This ratio in such a case, for judging the financial performance will be more or less irrelevant.
The overall profitability ratio suffers from certain important limitations. These are as under:
1. Manipulation Possible: the overall profitability ratio is based on earnings and investments. Both these figures can be manipulated by management by adopting varying accounting policies regarding depreciation, inventory valuation, treatment of provisions, etc… the decision in respect of most of these matters is arbitrary and subject to whims of the management.
2. Different Basis for Computation of Profits and Investments: There different bases for calculating both profits and investments. For e.g. fixed assets may be taken at gross or net values, earnings may be taken before or after tax, etc…
3. Emphasis on Short-Term Profits: The overall profitability ratio emphasises the generation of short-term profits. The firm may achieve this objective cutting down cost such as those on research and development or sales promotion. Cutting down of such cost without any justification may adversely affect the profitability of the company in the long run, though this ratio may indicate better performance in the short-run.
4. Poor Measure: The overall profitability ratio is a poor means of a firm’s performance since it is also affected by many extraneous and non-controllable factors. Often the present return is the result of the wisdom or the folly of the past management. Thus, the present management cannot take credit or be held responsible for the doing of their predecessors.
5. Undue Significance to Capital Resources: The overall profitability ratio gives undue significance to capital resources whereas profits are the result of contribution of various other inputs particularly human resources. However, their role is not clearly visible in the computation of overall profitability ratio.
6. Mars Initiative: The overall profitability ratio, when used as a measure for the evaluation of the performance of managers, may mar their initiative. Managers who are satisfied with the present ratio tend to become conservative and may not take any initiative to expand due to the fear of decrease in the profitability ratio. This would result in non-exploitation of the available opportunities and resources.
7. Chance Factor: Sometimes high or low profit may be due to chance. This ratio in such a case, for judging the financial performance will be more or less irrelevant.