Advantages and Limitations of Ratio Analysis

Advantages of Ratio Analysis

Ratio analysis is widely used in the analysis of the financial well-being of a business and is crucial to the understanding of the performance of organisations against one another.

It offers several benefits to organisations which are as follows:

• Ratio analysis is used for the analysis of financial statements
• Ratio analysis helps in simplifying accounting figures
• Ratio analysis is used to evaluate the operating efficiency of a business
• Ratio analysis helps in business forecasting
• Ratio analysis helps in identifying the weaknesses of an organisation
• Ratio analysis is used for making inter-firm or intra-firm comparisons

Ratio analysis is used for the analysis of financial statements

The different stakeholders in a business such as bankers, investors, creditors, etc. use ratio analysis methods to analyse the different financial statements of an organisation to assess its financial well-being.

For instance, fundamental analysis of an organisation by investors involves analysis of balance sheet and profit and loss statement of an organisation using ratio analysis.

Ratio analysis helps in simplifying accounting figures

Ratio analysis simplifies and organises a wide array of accounting figures to make them meaningful for the concerned parties. Financial ratios are used to summarise the results of the detailed and complicated computation which can lead to diagnosing the financial health of a firm.

Ratio analysis is used to evaluate the operating efficiency of a business

Ratio analysis helps in the diagnosis of an organisation’s financial health by evaluating its state of liquidity, solvency, profitability etc. This enables the management to assess and compare the financial states and capabilities of various business units.

Ratio analysis helps in business forecasting

Ratio analysis can also be used for forecasting the financial status and performance of an organisation in the future. Therefore, ratio analysis enables planning the future activities based on the forecasts made using ratio analysis.

For instance, ratio analysis may help in planning the course of action in the immediate future using ratio analysis to determine business trends over the years.

Ratio analysis helps in identifying the weaknesses of an organisation

In spite of satisfactory overall performance, an organisation may have certain drawbacks that need to be addressed by the management. Ratio analysis helps in identifying these weak spots in an organisation and taking remedial action.

For example, if an organisation discovers that the distribution expense is not proportional to the sales, the management would attempt to examine the situation and revise the distribution system.

Ratio analysis is used for making inter-firm or intra-firm comparisons

Organisations are interested in comparing their performance against the competitors’ performance or against the industry in general.

Such a comparison is referred to as inter-firm comparison while comparing the performance of different in an organisation is called intra-firm comparison. Both intra-firm as well as inter-firm comparisons can be performed using ratio analysis.

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Limitations of Ratio Analysis

However, ratio analysis has certain drawbacks that limit its use for financial analysis. These limitations are as follows:

• Incorrect or unauthenticated data may lead to wrong interpretations
• Dependence on historical data may not help in proper forecasts
• A single ratio does not provide sufficient information
• Different firms follow different accounting principles
• Price level changes may affect the forecasting
• Qualitative factors may get ignored
• Window dressing may affect interpretations based on ratio analysis
• Personal biases may affect the way the ratios are interpreted

Incorrect or unauthenticated data may lead to wrong interpretations

Ratio analysis depends on the data in the financial statements, which if not accurate or authenticated may lead to incorrect interpretation of results.

Dependence on historical data may not help in proper forecasts

Ratio analysis depends on the past data and thus, does not incorporate the current trends financial analysis. Forecasts based on historical data may not always lead to accurate trend prediction.

A single ratio does not provide sufficient information

A single ratio computed for a specific area is insufficient to interpret a significant conclusion thus, a series of ratios need to be calculated to ascertain the situation of a particular business area.

Different firms follow different accounting principles

Organisations may follow different accounting principles, which limit the use of inter-firm comparisons. Inter-firm comparisons are possible only when the organisations being compared follow uniform accounting principles and policies.

Price level changes may affect the forecasting

Changes in price level often distort the trend analysis process, which is carried out by computing a series of ratios for making forecasts.

Qualitative factors may get ignored

Financial Ratios are based on quantitative analysis of financial statements. Often qualitative facts need to be considered for making business decisions, which are ignored in ratio analysis.

For example, organisations give credit based on ratio analysis and ignore qualitative aspects such as character and managerial ability of the borrower. Under such circumstances, the conclusions derived from ratio analysis may prove to be misleading.

Window dressing may affect interpretations based on ratio analysis

Window dressing or manipulations of data in financial statements affects the results of ratio analysis.

Personal biases may affect the way the ratios are interpreted

Different people may interpret the same ratio in different ways. Personal judgment of the analyst affects the interpretation of results using ratio analysis.

If an analyst does not possess the required qualifications or is biased in interpreting the ratios, the conclusion drawn may prove to be misleading.