Importance and limitation of ratio analysis assignment help

Posted on April 26, 2017

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Ratio analysis is used to compare information taken from financial statements of a business for understanding of the results, financial position and cash flows of a business. However, there are a number of importance as well as limitation of ratio analysis and understanding this requires right knowledge and approach towards the subject.

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Importance of ratio analysis

 

Ratio analysis is a perfect tool to improve understanding of financial results of a business and its trends over time and provide key indicators of organizational performance. It also helps management to identify strength and weaknesses from which strategies can be made for any improvement if necessary. Few advantages of ratio analysis are as follows:
 

1) Analyzing financial position: Investors, bankers, managers and creditors etc uses ratio to analyze the financial situation of the company for their decision making.
 

2) Judging efficiency: Ratio analysis helps management to understand how well a company is able to utilize its assets and earn profits.
 

3) Locating weakness: It helps management to understand weakness of the company’s operations and take necessary measures to rectify them.
 

4) Formulating plans: Ratio analysis not only helps to analyze companies past performance but also formulate future plans.
 

5) Comparing performance: It is important for an organization to know how well it is performing from last few years and also keep a check with the other firms in the market to maintain its goodwill. Ratio analysis helps in these comparisons.
 

Limitation of ratio analysis

  • There are few limitations involved in ratio analysis discussed as under

1) Limitation of financial statement: Ratio is calculated from the information recorded in the financial statements of a business and it may suffer from a lot of limitations affecting the quality of ratio analysis.
 

2) Historical information: Financial statements provide historical information and not present condition of a business. So, it is not very helpful for future predictions.
 

3) Lack of accurate comparison: Ratio is said to be ideal if current assets are double the liabilities in books of accounts but this conclusion may not be right in case of business where there is already arrangements made for adequate fund from bankers when they require. Hence there is no fixed standard laid down for ideal ratios.
 

4) Different accounting policies: There is different policy followed regarding valuation of inventories, charging depreciation etc which makes data of two firms non-comparable.
 

There are other limitations of ratio analysis such as, a business might present incorrect data to show better financial position in the market, changes in the price level of fixed assets, seasonal factors may affect financial data etc.
 

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