Question

advantages and disadvantages of ratio analysis (use at least 6 references) and you are expected to make a literature review from previous project works or studies

Answer 1

Ratio analysis can be defined as the process of ascertaining the financial ratios that are used for indicating the ongoing financial performance of a company.Ratio analysis is a process used for the calculation of financial ratios or in other words, for the purpose of evaluating the financial wellbeing of a company. The values used for the calculation of financial ratios of a company are extracted from the financial statements of that same company.

DISADVANTAGES

• Company strategy. It can be dangerous to conduct a ratio analysis comparison between two firms that are pursuing different strategies. For example, one company may be following a low-cost strategy, and so is willing to accept a lower gross margin in exchange for more market share.
• Interpretation. It can be quite difficult to ascertain the reason for the results of a ratio.
• Business conditions. You need to place ratio analysis in the context of the general business environment.
• Accounting policies. Different companies may have different policies for recording the same accounting transaction. This means that comparing the ratio results of different companies may be like comparing apples and oranges.
• Operational changes. A company may change its underlying operational structure to such an extent that a ratio calculated several years ago and compared to the same ratio today would yield a misleading conclusion.
• Aggregation. The information in a financial statement line item that you are using for a ratio analysis may have been aggregated differently in the past, so that running the ratio analysis on a trend line does not compare the same information through the entire trend period.
• Inflation. If the rate of inflation has changed in any of the periods under review, this can mean that the numbers are not comparable across periods.
• Historical. All of the information used in ratio analysis is derived from actual historical results. This does not mean that the same results will carry forward into the future.

ADVANTAGE

• Forecasting and Planning:
• The trend in costs, sales, profits and other facts can be known by computing ratios of relevant accounting figures of last few years. This trend analysis with the help of ratios may be useful for forecasting and planning future business activities.
• Budgeting:
• Budget is an estimate of future activities on the basis of past experience. Accounting ratios help to estimate budgeted figures. For example, sales budget may be prepared with the help of analysis of past sales.
• Measurement of Operating Efficiency:
• Ratio analysis indicates the degree of efficiency in the management and utilisation of its assets. Different activity ratios indicate the operational efficiency. In fact, solvency of a firm depends upon the sales revenues generated by utilizing its assets.
• Communication:
• Ratios are effective means of communication and play a vital role in informing the position of and progress made by the business concern to the owners or other parties.
• Control of Performance and Cost:
• Ratios may also be used for control of performances of the different divisions or departments of an undertaking as well as control of costs.
• Inter-firm Comparison:
• Comparison of performance of two or more firms reveals efficient and inefficient firms, thereby enabling the inefficient firms to adopt suitable measures for improving their efficiency. The best way of inter-firm comparison is to compare the relevant ratios of the organisation with the average ratios of the industry.
• Indication of Liquidity Position:
• Ratio analysis helps to assess the liquidity position i.e., short-term debt paying ability of a firm. Liquidity ratios indicate the ability of the firm to pay and help in credit analysis by banks, creditors and other suppliers of short-term loans.