Advantages and Limitations of Ratio Analysis

Financial ratio analysis is a useful tool for users of financial statement. It has following advantages:

Advantages

  1. It simplifies the financial statements.
  2. It helps in comparing companies of different size with each other.
  3. It helps in trend analysis which involves comparing a single company over a period.
  4. 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.

Limitations

Despite usefulness, financial ratio analysis has some disadvantages. Some key demerits of financial ratio analysis are:

  1. 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.
  2. 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.
  3. Ratio analysis explains relationships between past information while users are more concerned about current and future information.

Written by Obaidullah Jan