ADVANTAGES & LIMITATIONS OF RATIO ANALYSIS

ADVANTAGES & LIMITATIONS OF RATIO ANALYSIS

  01:26    Rahul R

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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Ø  The figures in a set of accounts are likely to be at least several months out of date and so might not give a proper indication of the company’s current financial position.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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IMPORTANCE OF RATIO ANALYSIS

IMPORTANCE OF RATIO ANALYSIS

  01:19    Rahul R

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GUIDELINES OR PRECAUTIONS FOR USE OF RATIOS

The calculation of ratios may not be a difficult task but their use is not easy. Following guidelines or factors may be kept in mind while interpreting various ratios is

·         Accuracy of financial statements

·         Objective or purpose of analysis

·         Selection of ratios

·         Use of standards

IMPORTANCE OF RATIO ANALYSIS

 As a tool of financial statement, ratios are of crucial significance. The importance of ratio analysis lies in the fact that it presents facts on a comparative basis & enables the drawing of interference regarding the performance of a firm. Ratio analysis is relevant in assessing the performance of a firm in respect of the following aspects:

1)      Liquidity position

2)      Long-term solvency

3)      Operating efficiency

4)      Overall profitability

5)      Inter firm comparison

6)      Trend analysis

1)      Liquidity position

With the help of ratio analysis conclusion can be drawn regarding the liquidity position of firm. The liquidity position of a firm would be satisfactory if it is able to meet its current obligation when they become due. A firm can be said to have the ability to meet its short term liabilities if it has sufficient liquid funds to pay the interest on its short maturing debt usually within a year as well as to repay the principal. This ability is reflected in the liquidity ratio of a firm. The liquidity ratio is particularly useful in credit analysis by bank & other suppliers of short term loans.

2)      Long term solvency

Ratio analysis is equally useful for assessing the long term financial viability of a firm. This respect of the financial position of a borrower is of concern to the long term creditors, security analyst & the present & potential owners of a business. The long term solvency is measured by the leverage/capital structure & profitability ratio. Ratio analysis is that focus on earning power & operating efficiency.

Ratio analysis reveals the strength & weakness of a firm in this respect. The leverage ratios, for instance will indicate whether a firm has a reasonable proportion of various sources of finance or if it is heavily loaded with debt in which case its solvency is exposed to serious strain. Similarly the various profitability ratios whether or not the firm is able to offer adequate return to its owners consistent with the risk involved.

3)       Operating efficiency

Yet another dimension of the useful of the ratio analysis relevant from the viewpoint of management is that it throws light on the degree of efficiency in management & utilization of its assets. The various activity ratios measure this kind of operational efficiency. In fact, the solvency of a firm is in the ultimate analysis dependent upon the sales revenues generated by the use of its assets- total as well as its components.

4)      Overall profitability

Unlike the outsides parties, which are interested in one aspect of the financial position of a firm? The management is constantly concerned about overall profitability of the enterprise. That is, they are concerned about the ability of the firm to meets its short term as well as obligations to its creditors, to ensure a reasonable return to its owners & secure optimum utilization of the assets of the firm. This is possible if an integrated view is taken & all the ratios are considered together.

5)      Inter firm comparison

Ratio analysis not only throws light on the financial position of firm but also serves s a stepping-stone to remedial measures. This is made possible due to inter firm comparison & comparison with the industry averages. A single figure of a particular ratio is meaningless unless it is related to some standard or norm. One of the popular techniques is to compare the ratios of a firm with the industry averages. It should be reasonably expected that the performance of a firm should be in broad conformity with that of the industry to which it belongs. An inter firm comparison would demonstrate a firms position vice-versa its competitors. If the results are at variance either with the industry average or with those of the competitors, the firm can seek to indentify the probable & in light. Take remedial measure.

6)       Trend Analysis

Finally, ratio analysis enables a firm to take the time dimension into account. In other words, whether the financial position of a firm is improving or deteriorating over the years. This is made possible by the use of trend analysis. The significance of the trend analysis of ratio lies in the fact that the analyst can know the direction of movement. That is, whether the movement is favourable or unfavourable. For example, the ratio may be low as compared to the norm but the trend may be upward. On the other hand, though the present level may be satisfactory but the trend may be a declining one

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