Advantages of Ratio Analysis
Ratio analysis is a powerful tool of financial analysis. An absolute figure generally conveys no meaning. It is seen that mostly figure assumes importance only in background of other information. Ratios bring together figures which are significantly allied to one another to portray the cause and effect relationship.
From a study of the various ratios and their practical applications, the following advantages can be attributed to the technique of ratio analysis:
- It helps to analyse and understand financial health and trend of a business, its past performance, and makes it possible to forecast the future state of affairs of the business. They diagnose the financial health by evaluating liquidity, solvency, profitability etc. This helps the management to assess the financial requirements and the capabilities of various business units. It serves as a media to link the past with the present and the future.
- It serves as a useful tool in management control process, by making a comparison between the performance of the business and the performance of similar types of business.
- Ratio analysis play a significant role in cost accounting, financial accounting, budgetary control and auditing.
- It helps in the identification, tracing and fixing of the responsibilities of managerial personnel at different levels.
- It accelerates the institutionalisation and specialisation of financial management.
- Accounting ratios summarise and systematise the accounting figures in order to make them more understandable in a lucid form. They highlight the inter-relationship which exists between various segments of the business expressed by accounting statements.
Limitations of Ratio Analysis
Ratio analysis is a widely used technique to evaluate the financial position and performance of a business. But these are subject to certain limitations:
- Usefulness of ratios depend on the abilities and intentions of the persons who handle them. It will be affected considerably by the bias of such persons.
- Ratios are worked out on the basis of money-values only. They do not take into account the real values of various items involved. Thus, the technique is not realistic in its approach.
- Historical values (specially in balance sheet ratios) are considered in working out the various ratios. Effects of changes in the price levels of various items are ignored and to that extent the comparisons and evaluations of performance through ratios become unrealistic and unreliable.
- One particular ratio, in isolation is not sufficient to review the whole business. A group of ratios are to be considered simultaneously to arrive at any meaningful and worthwhile opinion about the affairs of the business.
- Since management and financial policies and practices differ from concern to concern, similar ratios may not reflect similar state of affairs of different concerns. Thus, comparisons of performance on the basis of ratios may be confusing.
- Ratio analysis is only a technique for making judgements and not a substitute for judgement.
- Since ratios are calculated on the basis of financial statements which are themselves affected greatly by the firm’s accounting policies and changes therein, the ratios may not be able to bring out the real situations.
- Ratios are at best, only symptoms; they may indicate what is to be investigated - only a careful investigation will bring out the correct position.
- Ratios are only as accurate as the accounts on the basis of which these are established. Therefore, unless the accounts are prepared accurately by applying correct values to assets and liabilities, the statements prepared therefrom would not be correct and the relationship established on that basis would not be reliable.