ADVANTAGES & LIMITATIONS OF RATIO ANALYSIS
Financial ratios are essentially concerned with the
identification of significant accounting data relationships, which give the
decision- maker insight into the financial performance of a company. The
advantages of ratio analysis can be summarized as follows:
·
Ratios
facilitate conducting trend analysis, which is important for decision making
and forecasting.
·
Ratio analysis
helps in the assessment of the liquidity, operating efficiency, profitability
and solvency of the firm.
·
Ratio analysis
provides a basis for both intra- firm as well as inter- firm comparisons.
·
The comparison
of actual ratios with base year ratios or standard ratios helps management
analyze the financial performance of the firm.
LIMITATIONS
OF RATIO ANALYSIS
Ratio analysis has limitations.
These limitations are described below:
1. Information problems
Ø Ratios require quantitative information for analysis
but it is not decisive about analytical output.
Ø The figures in a set of accounts are likely to be at
least several months out of date and so might not give a proper indication of
the company’s current financial position.
Ø Where historical cost convention is used, asset
valuations in the balance sheet could be misleading. Ratios based on this
information will not be very useful for decision- making.
2. Comparison of performance over time
Ø When comparing performance over time, there is need
to consider the changes in price. The movement in performance should be in line
with the changes in price.
Ø When comparing performance over time, there is need
to consider the changes in technology. The movement in performance should be in
line with the changes in technology.
Ø Changes in accounting policy may affect the
comparison of results between different accounting years as misleading.
3. Inter-firm comparison
Ø Companies may have different capital structures and
to make comparison of performance when one is all equity financed and another
is a geared company it may not be a good analysis.
Ø Selective application of government incentives to
various companies may also distort intercompany comparison. Comparing the
performance of two enterprises may be misleading.
Ø Inter- firm comparison may not be useful unless the
firms compared are of the same size and age and employ similar production
methods and accounting practices.
Ø Even within a company, comparisons can be distorted
by changes in the price level.
Ø Ratios provide only quantitative information not
qualitative information.
Ratios are calculated on the basis of past financial
statements. They do not indicate future trends and they do not consider
economic conditions. Evaluation of efficiency.Effective tool
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