Meaning, Objectives, Advantages, Limitations & Significance of Ratio Analysis

Today in this article let us discuss Ratio Analysis meaning, objectives of ratio analysis and advantages and limitations of Ratio Analysis.

Ratio Analysis

          Ratio Analysis is a method of financial statement analysis that is used to obtain a quick indication of a firm’s financial performance in key areas. Thus from this we can derive that ratio analysis is a study of relationships between various financial factors of a firm. Ratio Analysis is an inseparable part of interpretation of financial statements.

Objectives of Ratio Analysis

          Ratio Analysis provides users with crucial financial info and points from areas which require investigation. It is a technique which groups data by applying arithmetical relationships through its interpretation in complex manner. The objectives of ratio analysis are,

§     Helps to understand the areas of business which require more focus.

§    To discover the potential areas of the business that can be improved with the efforts by desired directions.

§    To provide the deep insights of profitability, liquidity, solvency and efficiency levels of firm.

§   Ratio Analysis provides the information for cross section analysis by comparing the performance with the best industry standards.

§  Ratio Analysis provides information derived from financial statements useful for projections and forecasts for the future.

Advantages of Ratio Analysis

          The advantages of ratio analysis are as follows,

§  Ratio Analysis when carried out properly improves the user’s understanding of the business efficiency.

§  Ratio Analysis helps to throw lights on numerical relationships between various factors of the business.

§  Ratio Analysis helps you to analyze and understand the various problems of the business.

§  Ratio Analysis helps to understand whether you have made the right investing, financing and operations decisions.

§  Ratio Analysis establishes the relationships between complex accounting figures and helps to summarize the financial information effectively and assess the managerial effectiveness, firm’s creditworthiness, earning capacity and so on.

§  Ratio Analysis helps to discover the trends visible in the business when the figures of various years are kept side by side. This helps you to understand and make future forecasts and projections for the business.

§  Ratio Analysis helps you to assess and understand the problems in the business but at the same time it also tells you about the areas of the business that are performing good and if paid a bit more attention then they will become excellent. While areas of problems needs your attention and time to bring the areas back on track.

§  Ratio analysis is a great tool to carry out the SWOT Analysis of the business and provide the information to the management about the opportunities and threats that are in front of the company.

§  Ratio Analysis helps the company to assess who well it is performing in industry by assesses the infra-firm comparison, inter-firm comparison and comparison with standards or industry expectations.

Limitations of Ratio Analysis

          The limitations of Ratio Analysis are as follows,

§  The Ratio Analysis is totally dependent on the financial statements prepared and the accounting data. Thus the soundness of judgment necessarily depends on the competence and integrity who make and adherence the GAAP and Conventions.

§  Ratio Analysis ignores the price changes. Since the financial accounting is based in money measurement principle which implies that there is no changes in price level or minimal changes in price levels but we live in an inflationary economies where value of money constantly declines. Since Financial Accounting ignores value of money concept so does the ratio analysis which is totally depend on it.

§  Ratio Analysis ignores non-monetary and qualitative aspects because financial accounting data ignores it and only reflects quantitative and monetary aspects only.

§  Variation of accounting practices raises a big question mark on cross-sectional analysis and also   a valid comparison of the financial statements is not possible because of the variation of accounting practices in different companies or firms.

§  Ratio Analysis gives the trends based on historical recorded data of monetary and quantitative data but forecasting requires considering non-financial aspects as well for the proper forecasting. Thus a forecasting limitations based on ratio analysis trends do exists.

Uses and Significance of Ratio Analysis

          The uses and significance of ratio analysis are as follows,

§  Ratio Analysis helps you to check upon the efficiency with which the working capital is being used in business.

§  It helps financial management to evaluate the financial position and performance of the business.

§  Ratio Analysis helps in Cost Control by establishing standard costing systems and budgetary systems.

§  Ratio Analysis is an efficient mode of communication.

§  Ratio Analysis is helpful in inter-firm comparison and infra-firm comparison.

§  Ratio Analysis helps management to make decisions, formulate policies and performance appraisal.

We can conclude that ratio analysis has many advantages and limitations and significance. But Ration Analysis is definitely an instrument for diagnosing the financial conditions of the business and analyzes the financial statements of business.