PURPOSE, UTILITY & LIMITATIONS OF RATIO ANALYSIS - Accounts and Finance for Managers

Purposes of Ratio Analysis

Purposes of the Ratio Analysis are:

  • To study the short term solvency of the firm – liquidity of the firm
  • To study the long term solvency of the firm – leverage position of the firm
  • To interpret the profitability of the firm – Profit earning capacity of the firm
  • To identify the operating efficiency of the firm. – turnover of the ratios

Utility of the Ratio Analysis are:

  1. Easy to understand the financial position of the firm: The ratio analysis facilitates the parties to read the changes taken place in the financial performance of the firm from one time period to another.
  2. Measure of expressing the financial performance and position: It acts as a measure of financial position through Liquidity ratios and Leverage ratios and also a measure of financial performance through Profitability ratios and Turnover Ratios.
  3. Intra-firm analysis on the financial information over many number of years:The financial performance and position of the firm can be analysed and interpreted with in the firm in between the available financial information of many number of years; which portrays either increase or decrease in the financial performance.
  4. Inter-firm analysis on the financial information within the industry: The financial performance of the firm is studied and interpreted along with the similar firms in the industry to identify the presence and status of the respective firm among others.
  5. Possibility for Financial planning and control: It not only guides the firm to earn in accordance with the financial forecasting but also facilitates the firm to identify the major source of expense which drastically has greater influence on the earnings.

Limitations of the Ratio Analysis are:

  1. It is dependant tool of analysis: The perfection and effectiveness of the analysis mainly depends upon the preparation of accurate and effectiveness of the financial statements. It is subject to the availability of fair presentation of data in the financial statements.
  2. Ambiguity in the handling of terms: If the tool of analysis taken for the study of inter firm analysis on the profitability of the firms lead to various complications. To study the profitability among the firms, most required financial information are profits of the enterprise. The profit of one enterprise is taken for analysis is Profit After Taxes (PAT) and another is considering Profit Before Interest and Taxes (PBIT) and third one is taking Net profit for study consideration. The term profit among the firms for the inter firm analysis is getting complicated due to ambiguity or poor clarity on the terminology.
  3. Qualitative factors are not considered: Under the ratio analysis, the quantitative factors only taken into consideration rather than qualitative factors of the enterprise. The qualitative aspects of the customers and consumers are not considered at the moment of preparing the financial statements but while granting credit on sales is normally considered.
  4. Not ideal for the future forecasts: Ratio analysis is an outcome of analysis of historical transactions known as Postmortem Analysis. The analysis is mainly based on the yester performance which influences directly on the future planning and forecasting ; it means that the analysis is mainly constructed on the past information which will also resemble the same during the future analysis.
  5. Time value of money is not considered: It does not give any room for time value of money for future planning or forecasting of financial performance; the main reason is that the fundamental base for forecasting is taken from the yester periods which never denominate the timing of the benefits.

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