Ratio Analysis : Advantages and Limitations in Financial Management

Ratio Analysis : Advantages and Limitations in Financial Management

What is Ratio Analysis :

Ratio analysis is the method or process by which the relationship of items or groups of items in the financial statements are computed, determined and presented.

Ratio analysis is an attempt to derive quantitative measures or guides concerning the financial health and profitability of the business enterprise. Ratio analysis can be used both in trend and static analysis.

There are several ratios at the disposal of the analyst but the group of ratios he would prefer depends on the purpose and the objectives of the analysis.

Accounting ratios are effective tools of analysis. They are indicators of managerial and overall operational efficiency. Ratios, when properly used are capable of providing useful information.
Ratio analysis is defined as the systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined the term ratio refers to the numerical or quantitative relationship between items/ variables.

This relationship can be expressed as:

1) Fraction

2) Percentages

3) Proportion of numbers
These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratio does not add any information in the figures of profit or sales.
What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them.

ADVANTAGE OF RATIO ANALYSIS :

Ratios simplify and summarize numerous accounting data in a systematic manner so that the simplified data can be used effectively for analytical studies.
Ratios avoid distortions that may result the study of absolute data or figures.
Ratios analyze the financial health, operating efficiency and future prospects by inter-relating the various financial data found in the financial statement.
Ratios are invaluable guides to management. They assist the management to discharge their functions of planning, forecasting, etc. efficiently.
Ratios study the past and relate the findings to the present. Thus useful inferences are drawn which are used to project the future.
Ratios are increasingly used in trend analysis.
Ratios being measures of efficiency can be used to control efficiency and profitability of a business entity.
Ratio analysis makes inter-firm comparisons possible. i.e. evaluation of interdepartmental performances.
Ratios are yard stick increasingly used by bankers and financial institutions in evaluating the credit standing of their borrowers and customers.

LIMITATIONS OF RATIO ANALYSIS:

An investor should caution that ratio analysis has its own limitations. Ratios should be used with extreme care and judgment as they suffer from certain serious drawbacks.

Some of them are listed below:

1. Rations can sometimes be misleading if an analyst does not know the reliability andsoundness of the figures from which they are computed and the financial position of the business at other times of the year.
A business enterprise for example may have an acceptable current ratio of 3:1 but a larger part of accounts receivables comprising a great portion of the current assets may be uncollectible and of no value. When these are deducted the ratio might be 2:1.

2. It is difficult to decide on the proper basis for comparison. Ratios of companies have meaning only when they are compared with some standards. Normally, it is suggested that ratios should be compared with industry averages. In India, for example, no systematic and comprehensive industry ratios are complied.

3. The comparison is rendered difficult because of differences in situations of 2 companies are never the same. Similarly the factors influencing the performance of a company in one year may change in another year.
Thus, the comparison of the ratios of two companies becomes difficult and meaningless when they are operation in different situations.

4. Changes in the price level make the interpretations of the ratios Invalid.

The interpretation and comparison of ratios are also rendered invalid by the changing value of money.

The accounting figures presented in the financial statements are expressed in monetary unit which is assumed to remain constant. In fact, prices change over years and as a result.

Assets acquired at different dates will be expressed at different values in the balance sheet. This makes comparison meaningless.

For e.g. two firms may be similar in every respect except the age of the plant and machinery. If one firm purchased its plant and machinery at a time when prices were very low and the other purchased when prices were high, the equal rates of return on investment of the two firms cannot be interpreted to mean that the firms are equally profitable.

The return of the first firm is overstated because its plant and machinery have a low book value.

5. The differences in the definitions of items, accounting, policies in the balance sheet and the income statement make the interpretation of ratios difficult.

In practice difference exists as to the meanings and accounting policies with reference to stock valuation, depreciation, operation profit,current assets etc.

Should intangible assets be excluded to calculate the rate of return on investment? If intangible assets have to be included, how will they be valued? Similarly, profit means different things to different people.

6. Ratios are not reliable in some cases as they many be influenced by window/ dressing in the balance sheet.

7. The ratios calculated at a point of time are less informative and defective as they suffer from short-term changes. The trend analysis is static to an extent.

The balance sheet prepared at different points of time is static in nature. They do not reveal the changes which have taken place between dates of two balance sheets. The statements of changes in financial position reveal this information, bur these statements are not available to outside analysts.

8. The ratios are generally calculated from past financial statements and thus are no indicator of future. The basis to calculate ratios are historical financial statements. The financial analyst is more interested in what happens in future.