Question

What are the benefits of ratio analysis? What are the limitations of ratio analysis? What can be done to minimize the limitations on ratio analysis? Explain. Cite any references used.

Answer 1

Financial ratios are not very useful on a stand-alone basis; they must be benchmarked against something. Analysts compare ratios against the following:

1.The Industry norm - This is the most common type of comparison. Analysts will typically look for companies within the same industry and develop an industry average, which they will compare to the company they are evaluating. Ratios per industry are also provided by Bloomberg and the S&P. These are good sources of general industry information. Unfortunately, there are several companies included in an index that can distort certain ratios. If we look at the food and beverage ratio index, it will include companies that make prepared foods and some that are distributors. The ratios in this case would be distorted because one is a capital-intensive business and the other is not. As a result, it is better to use a cross-sectional analysis, i.e. individually select the companies that best fit the company being analyzed.

2.Aggregate economy - It is sometimes important to analyze a company's ratio over a full economic cycle. This will help the analyst understand and estimate a company's performance in changing economic conditions, such as a recession.

3.The company's past performance - This is a very common analysis. It is similar to a time-series analysis, which looks mostly for trends in ratios.

There are 03 types of ratios :

• Liquidity ratios.
• Leverage ratios .
• Profitability ratios.

Limitations of Financial Ratios

• Based on historical accountancy
• Transfer inefficiencies
• Do not consider the effects of inflation
• Doesn't tell any thing on it's own
• Companies can doctor their financial statements
• Lack of ratio analysis knowhow
• Does not factor in changes
• Does not consider non financial factors
• Encourages sub optimal decision making

Steps to overcome :

We should not completely depend on these ratios in decision making .

We should consider these for final decisions .

We should use this as a tool for information only .

And some decisions can be based on purly relying on these .