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Advantages and Limitations of Ratio Analysis

What are the advantages and limitations of ratio analysis?

Advantages:

  • It is an important and useful tool to determine the efficiency with which working capital is being managed in a business organization.
  • It is a ‘health test‘ for a business firm in that it can gauge whether the firm is financially healthy or not.
  • It aids the management of business concern in evaluating its financial position and performance efficiency.
  • It clearly shows the trend of changes in the market position (upward, downward or static), as it covers a number of previous accounting (financial) periods.
  • The progress or downfall of a firm is clearly indicated by this analysis.
  • It assists in preparing financial estimates for the future (financial forecasting).
  • It facilitates the task of managerial control to a great extent.
  • It helps the credit suppliers and investors in deciding upon a business firm as a potential investment outlet or desirable debtor.
  • Ideal or Standard ratios can be established which can be used as reference points of comparison for a firm’s progress over a period of time.
  • It communicates important information with relation to financial strength, earning capacity, debt (borrowing) capacity, liquidity position, capacity to meet fixed commitments, solvency, capital gearing, working capital management, future prospects etc. of a business concern.
  • This analysis is also useful for bench marking purpose- to compare the working result and efficiency of performance of a business enterprise with that of other firms engaged in the same industry (inter-firm comparison).
  • It helps the management to discharge their basic functions of planning, coordinating, controlling etc.
  • It serves as an instrument for testing management efficiency too.
  • It acts as a useful tool for deciding on certain policy matters.

Advantages and Limitations of Ratio Analysis

Limitations:

  • Accounting ratios calculated based on ratio analysis will be correct only if the accounting data on which they are based are correct.
  • It is only an analysis of past financial data.
  • In certain cases ratio analysis might prove to be misleading with regard to profits.
  • Continuous fluctuation in price levels ( or, purchasing power of money) seriously affect the validity or comparison of accounting ratios calculated for different accounting periods and make such comparisons very difficult.
  • Comparisons become difficult also on account of difference in the definition of several financial (accounting) terms like gross profit, operating profit, net profit etc.
  • There is lot of diversity in practice as regards to the measurement of ratios.
  • Different firms use different accounting methods and the validity of comparison is severely affected by window dressing in the basic financial statements.
  • A single ratio will not be able to convey much information.
  • This analysis only gives part of the total information required for proper decision-making.
  • This should not be taken as a substitute for sound judgement.
  •  It should not be overlooked that business problems cannot be solved mechanically through ratio analysis or other types of financial analysis.

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