Question

“Financial ratios calculated and analyzed in a particular situation depend on the user of
the financial statements.”- Expound the advantages and limitations of ratio analysis.

Answer 1

Financial ratio analysis is useful tool for comparison of two or more companies financial aspects. Comparison is not reliable always when there is difference in the size of businesses. It enables comparison across different periods of a single business also. Different financial ratios are available to analyze different aspects of a business like financial position and performance. Financial ratios calculated and analyzed in a particular situation depend on the user of the financial statements.

Advantages

• Ratio analysis is useful for planning future business activities.
• It helps to prepare budgets.
• Helps to measure the degree of efficiency of the business
• It is used for control of performances
• Ratios help to assess the liquidity position
• It helps to measure the long-term debt-paying capacity of a firm
• Ratios help to measure overall profitability
• Helps in measuring Financial Position

Disadvantages

• The limitations of financial statements affect the quality of ratio analysis.
• No Common Standards are set for all ratios.
• Variation in Accounting Methods used by the companies affect the results when the ratios are compared.
• Financial statements used in the ratio analysis are only historical information. Current position is not reflected in the ratios.
• The results of ratio analysis can be a kind of ‘window-dressing’. That means the results may show a better position than what it actually is.
• Ratios are tools of quantitative analysis. It ignores qualitative factors