Advantages and Disadvantages of Ratio Analysis

Ratios are an expression of one number in terms of another. This form of analysis facilitates comparison between the financial performances of different businesses or industries. Ratio, vertical and horizontal analysis are commonly used by financial analysts because they are useful tools for planning, controlling and monitoring an organisational performance. A range of financial ratios are there, including: liquidity, solvency, profitability, efficiency and investor ratios.

Advantages of ratio analysis include:

  • Ratio analysis enables the users of the financial statement to make comparisons between the financial performances of two or more businesses, even if they are of different sizes or from different industries, by converting financial numbers into standardized form using pre-defined formulas.
  • Ratios are easy to calculate and do not consume significant amount of time.

Disadvantages of ratio analysis include:

  • One of the primary disadvantages of ratio analysis is that it is underpinned by numbers contained within the financial statements. Thus, if the numbers contained within the financial statements were subject to management bias, ratio analysis would give inaccurate results.
  • The lack of ideal ratios makes it difficult for the users of the financial statements to assess whether a particular ratio is good or bad. For instance, higher the current ratio, the better it is. Nonetheless, a business with exceptionally high current ratio could be reflective of the inability of a business to use its funds efficiently. Thus, the absence of any definitive guidelines regarding its interpretation limits its utility in the real world.
  • Since different businesses adopt different accounting policies and estimates, the comparison between two businesses would not yield effective results if the accounting policies and estimates adopted by the two businesses are different.
  • Ratio analysis is historical in nature, whereas most users of financial statements are interested in acquiring information about the future.

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