A ‘Ratio: is defined as an arithmetical/quantitative/numerical relationship between two numbers. Ratio analysis is a very important and age old technique of financial analysis.
Uses of Ratio Analysis: There are various uses of Ratio analysis, some of which are as follows:
1. It helps in managerial decision making
2. It helps in financial forecasting and planning
3. It helps in communicating the financial strength of a concern
4. It helps in control
5. It is an essential part of budgetary control and Standard costing
6. It helps an investor/prospective investor in decision making
7. It provides information to the creditors about the solvency of the firm
8. It helps the employees by providing information about the profitability of the concern
9. It helps the government in policy making by providing financial information about the industry/firm etc
10. It facilitates inter-firm; intra-firm; and firm-industry comparison
Limitations of Ratio Analysis: In spite of the various uses of ratio analysis, it suffers from certain limitations, some of which are as under
1. Limited use of a single ratio: A single ratio does not convey any meaning. Ratios are useful only when calculated in sufficient nos.
2. Lack of adequate standards: It is difficult to set ideal ratios for each firm/industry. And also setting of standard ratios for all the firms in every industry is also difficult.
3. Inherent limitations of accounting: As Ratio analysis is based on financial statements, the analysis suffers from the limitations of financial statements.
4. Change of accounting procedure: If different methods are followed by different firms for their valuation, comparison will practically be of no use.
5. Window dressing: Ratios based on dressed up (manipulated) financial information are not of much use as they show unreliable position of the firm
6. Personal bias: Different people will interpret the same ratio in different ways. Thus, there is always the possibility that interpretation of the data may be different for different people, and this in turn may result in many inferences for the same data, which may be confusing.
7. Price level changes are not provided for in ratio analysis which may lead to a misleading interpretation of a business operations
8. Ignorance of qualitative factors: Ratios are tools of quantitative analysis only and normally qualitative factors which may generally influence the conclusions, (ex – a high current ratio may not necessarily mean sound liquid position when current assets include a large inventory consisting mostly of obsolete items) are ignored while they are calculated.
Uses of Ratio Analysis: There are various uses of Ratio analysis, some of which are as follows:
1. It helps in managerial decision making
2. It helps in financial forecasting and planning
3. It helps in communicating the financial strength of a concern
4. It helps in control
5. It is an essential part of budgetary control and Standard costing
6. It helps an investor/prospective investor in decision making
7. It provides information to the creditors about the solvency of the firm
8. It helps the employees by providing information about the profitability of the concern
9. It helps the government in policy making by providing financial information about the industry/firm etc
10. It facilitates inter-firm; intra-firm; and firm-industry comparison
Limitations of Ratio Analysis: In spite of the various uses of ratio analysis, it suffers from certain limitations, some of which are as under
1. Limited use of a single ratio: A single ratio does not convey any meaning. Ratios are useful only when calculated in sufficient nos.
2. Lack of adequate standards: It is difficult to set ideal ratios for each firm/industry. And also setting of standard ratios for all the firms in every industry is also difficult.
3. Inherent limitations of accounting: As Ratio analysis is based on financial statements, the analysis suffers from the limitations of financial statements.
4. Change of accounting procedure: If different methods are followed by different firms for their valuation, comparison will practically be of no use.
5. Window dressing: Ratios based on dressed up (manipulated) financial information are not of much use as they show unreliable position of the firm
6. Personal bias: Different people will interpret the same ratio in different ways. Thus, there is always the possibility that interpretation of the data may be different for different people, and this in turn may result in many inferences for the same data, which may be confusing.
7. Price level changes are not provided for in ratio analysis which may lead to a misleading interpretation of a business operations
8. Ignorance of qualitative factors: Ratios are tools of quantitative analysis only and normally qualitative factors which may generally influence the conclusions, (ex – a high current ratio may not necessarily mean sound liquid position when current assets include a large inventory consisting mostly of obsolete items) are ignored while they are calculated.
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