Advantages and Limitations of Ratio Analysis
Financial ratio analysis is a useful tool for users of financial statement. It has following advantages:
- It simplifies the financial statements.
- It helps in comparing companies of different size with each other.
- It helps in trend analysis which involves comparing a single company over a period.
- It highlights important information in simple form quickly. A user can judge a company by just looking at few numbers instead of reading the whole financial statements.
Despite usefulness, financial ratio analysis has some disadvantages. Some key demerits of financial ratio analysis are:
- Different companies operate in different industries each having different environmental conditions such as regulation, market structure, etc. Such factors are so significant that a comparison of two companies from different industries might be misleading.
- Financial accounting information is affected by estimates and assumptions. Accounting standards allow different accounting policies, which impairs comparability and hence ratio analysis is less useful in such situations.
- Ratio analysis explains relationships between past information while users are more concerned about current and future information.
Written by Obaidullah Jan, ACA, CFA