Importance And Limitations Of Ratio Analysis

Importance And Limitations Of Ratio Analysis

Importance

As a tool of financial management, ratios are of crucial significance. The importance of ratio analysis lies in the fact that it presents facts on a comparative basis and enables the drawing of inferences regarding the performance of a firm. Ratio analysis is relevant in assessing the performance of a firm in respect of the following aspects: (i) liquidity position, (ii) long-term solvency, (iii) operating efficiency, (iv) overall profitability, (v) inter-firm comparison, and (vi) trend analysis.

Liquidity Position

With the help of ratio analysis conclusions can be drawn regarding the liquidity position of a firm. The liquidity position of a firm would be satisfactory if it is able to meet its current obligations when they become due. A firm can be said to have the ability to meet its short-term liabilities if it has sufficient liquid funds to pay the interest or its short-:maturing debt usually within a year as well as to repay the principal. This ability is reflected in the liquidity ratios of a firm. The liquidity ratios are particularly useful in credit analysis by banks and other suppliers of short-term loans.

Long-term Solvency

Ratio analysis is equally useful for assessing the long-term financial viability of a firm. This aspect of the financial position of a borrower is of concern to the long-term creditors, security analysts and the present and potential owners of a business. The long-term solvency is measured by the leverage/capital structure and profitability ratios which focus on earning power and operating efficiency.
Ratio analysis reveals the strengths and weaknesses of a firm in this respect. The leverage ratios, for instance, will indicate whether a firm has a reasonable proportion of various sources of finance or if it is heavily loaded with debt in which case its solvency is exposed to serious strain. Similarly, the various profitability ratios would reveal whether or not the firm is able to
offer adequate return to its owners consistent with the risk involved.

Operating Efficiency

Yet another dimension of the usefulness of the ratio analysis, relevant from the viewpoint of management, is that it throws light on the degree of efficiency in the management and utilisation of its assets. The various activity ratios measure this kind of operational efficiency. In fact, the solvency of a firm is, in the ultimate analysis, dependent upon the sales revenues generated by the use of its assets-total as well as its components.

Limitations

Ratio analysis is a widely used tool of financial analysis. Yet, it suffers from various limitations. The operational implication of this is that while using ratios, the conclusions should not be taken on their face value. Some of the limitations which characterise ratio analysis are (i) difficulty in comparison, (ii) impact of inflation, and (iii) conceptual diversity.
Difficulty in Comparison One serious limitation of ratio analysis arises out of the difficulty associated with their comparability. One technique that is employed is inter-firm comparison. But such comparisons are vitiated by different procedures adopted by various firms. The differences may relate to:
 Differences in the basis of inventory valuation (e.g. last in first out, first in first out, average cost and cost)
 Different depreciation methods (i.e. straight line vs written down basis);
 Estimated working life of assets, particularly of plant and equipment;
 Amortisation of intangible assets like goodwill, patents and so on;
 Amortisation of deferred revenue expenditure such as preliminary expenditure and. discount on issue of shares;
 Capitalisation of lease;
 Treatment of extraordinary items of income and expenditure; and so on.
Secondly, apart from different accounting procedures, companies may have different accounting periods, implying differences in the composition of the assets, particularly current assets. For these reasons, the ratios of two firms may not be strictly comparable.
Another basis of comparison is the industry average. This presupposes the availability, on a comprehensive scale, of various ratios for each industry group over a period of time. If, however, as is likely, such information is not- compiled and available, the utility of ratio analysis would be limited.