Importance/Advantages of Ratio Analysis: Ratio analysis attempts to

establish the significance of one numerical figure on the basis of its

relationship with another numerical figure. No doubt, in the present day
financial analysis ratio analysis is a very important tool. Whether an
organisation is financially sound or not, how much shock absorbing
capacity it has, whether its prospect is good or bleak that can be adjudged
with the help of ratio analysis.
Sometimes the tool of ratio analysis is compared with the blood pressure,
pulse or temperature of a human being. As a medical expert diagnose the
disease and comes to a conclusion as to the health of an individual with the
help of such symptoms, similarly a financial analyst makes a critical
assessment of an organisations financial health with the help of different
ratios. He also suggests for the measures needed to overcome the weakness,
if any detected through such analysis. The importance and utility of ratio
analysis as a tool of financial management may be discussed under the
following heads:
(i) Expression in a simplified and condensed form: The detailed
information expressed in financial statements can be presented through
ratio analysis in a simple, easily understand and brief form. Such simple
presentation helps even the non-accounting persons to understand various
information easily and quickly.
(ii) Analysis of financial position: The financial position of an organisation
can be judged through ratio analysis. What is the financial position of the
concern and what are the reasons responsible for that can be analysed with
the help of ratios. The financial analyst does not only identify the weak
points of the financial position, he also gives advice on the remedial
measures.
(iii) Measurement of overall efficiency: Ratio analysis is often used as an
index of measuring efficiency. Ratios can be used not only for measuring
individual and departmental efficiency: efficiency in managerial performance
can also be determined through ratios. For this reason the system of ratio
analysis is often used as a controlling instrument in the hands of
management.
(iv) Inter-firm and inter-department comparison: With the help of ratio
analysis the financial position, capital structure, profitability, solvency,
efficiency, etc. of an organisation can be compared with the same of the
other firms belonging to the same industry and also with the overall
industry standard. Besides, this tool can also be utilised for effecting
comparison among different departments of the same firm in relation to the
targets set, works performed and relative efficiency. Such inter-firm and
inter. departmental comparisons are helpful to evaluate the real financial
condition of any organisation.
(v) Measurement of solvency: An idea about the short-run and long-run
loan repayment capacity or solvency of a concern can be made by computing
different ratios for this purpose and making an in-depth analysis of the
same. The present solvency position of a firm can be assessed by means of
drawing a comparison of the current ratios with the ratios of earlier years.
Such measurement of solvency does not only help management in its
decision making process, it also helps the investors and creditors to take
their investment decisions.
(vi) Measurement of profitability: Ascertainment of the profitability trend
of a firm is another benefit of ratio analysis. Computation of certain ratios
like Gross Profit Ratio, Net Profit Ratio. Operating Profit Ratio, Return on
Capital Employed, etc. helps measuring a firms current years profitability.
Similarly comparison of the current years ratios with those of the earlier
years helps projecting the profitability trend of the firm. Comparison of the
profitability ratios of one firm with the same of its counterparts belonging to
the same industry gives a clearer picture of the profit earning capacity.
(vii) Help in planning and forecasting: Trends of different strategic ratios
help management in planning and forecasting. By using different ratios
computed on the basis of information published in financial statements of
past years, forecasting of saes, different revenue expenses, capital
expenditure, etc. is made and budgets are prepared. Information revealed by
past ratios is also used in the formulation of future financial policies.
(viii) Help in decision making: Organisational and departmental efficiency
are evaluated through ratio analysis. The assessment of work performed and
measurement of the efficacy in the use of resources make the trends
indicated by such analysis dependable. For this reason management often
takes many vital decisions on the basis of computed ratios.
(ix) Help in taking corrective measures: The financial analysts and
management accountant identify the areas of weakness and inefficiencies on
the basis of the trend indicated by ratios and suggest remedial measures to
overcome them. This helps the management to control financial affairs and
take corrective actions to rectify the wrong decisions.
(x) Help in controlling : Analytical data available through ratio analysis
helps controlling the trading and non-trading activities of the firm and the
related costs. The trend of different expense ratios makes management
aware of the necessity of controlling-different costs and identifies the specific
areas of control.
(xi) Help in communication: Probably ratio analysis is one of the popular
most techniques of communicating accounting information in brief. It is
possible to communicate flamboyant and composite data in a nut and shell
and simple form through ratios. For this reason at present ratio analysis is
accepted as a common medium of effecting interdepartmental and inter-firm
communication. The managers of different levels communicate information
within themselves through ratios.
(xii) Useful to the outsiders: Ratio analysis is indeed an well-accepted and
widely used tool of supplying necessary information to the management. In
addition it is also considered as an important technique even to the outside
parties associated with any business or non-business institution. The
outsiders like potential investors, banks and other financial agencies,
creditors, government, income-tax authority and others depend a lot on the
analysed information available through ratio analysis for setting up
business relation, maintaining the link with the firm, taking important
decisions on different issues, etc. Even at present the researchers on
accounting and management fields take the help of ratio analysis for the
purpose of evaluation of performance, measurement of trends and
projection of future potentials.

Limitations of Ratio Analysis
It can be undoubtedly said that ratio analysis is one of the widely used and
popular financial techniques of the modern times. But in many cases its
effective application largely depends on the expertise and analytical skill of
the interpreter. It is not possible to obtain the expected utility from ratio
analysis unless the ratios are properly used and interpreted. So despite
having immense benefits ratio analysis technique is not an unmixed
blessings. The arguments put forward by the critics against the technique of
ratio analysis are as follows:
i) Completely based on comparison: It is not possible to analyse any
particular matter with the help of a single ratio. Such analysis is possible by
making comparison of at least two or more ratios. Whether a particular
trend indicated by any ratio is good or bad, favourable or unfav.oirable that
can only be judged through comparative analysis. Comparison is only one of
the techniques of making analysis, but in case of ratio analysis it is the sole
technique. For this reason u is said that ratio analysis is only a partial
analytical process, not a complete one.
(ii) Difficult to fix up definite standards: The real significance of a
particular ratio can be understood by curiiparing it with any ideal or
standard norm of that ratio. But the standard already fixed on for a ratio
may change over time. Moreover, standard ratios of the industry to which
the firm belongs may be fixed up on different basis and may vary widely with
the computed ratios of the firm. Standards may also differ according to the
nature of the situations. So fixing up acceptable standards for all the ratios
is not doubt an uphill task.
(iii) Dependence on financial statements: Ratios are always based on
information disclosed in basic financial statements like the Profit and Loss
Account and the Balance Sheet. Financial statements have their own
limitations. So ratios computed on the basis of information disclosed in
those financial statements cannot also be free from such limitations. For
getting rid of these limitations before computing ratios some adjustments
are required to be ma-dc in the information disclosed in financial
statements. In reality it is not done and so ratios always suffer from the
limitations of the financial statements.
(iv) Problem of inter-firm comparison: In case there is significant
variations in accounting policies adopted by different firms belonging to the
same industry the inter-firm comparison through ratio analysis does not
become effective. For example it can be said that if the policies relating to
inventory valuation, depreciation, treatment of contingent liabilities, etc. of
two firms under the same industry are different the trend indicated by an
inter-firm comparison through ratios does not carry any effective meaning.
(v) Personal influence: The utility of ratio analysis depends a lot on the skill
and judgement of the interpreter. If the personal sense of judgement and
analytical power of different interpreters vary a particular ratio may indicate
different trends. So presence of personal aptitude reduces the effectiveness
of ratio analysis. Moreover, the interpreters may exert undue influence on
their analysis with unfair motives.
(vi) Only quantitative analysis: Ratios are often called quantitative tools
because their computations are based on only quantitative or numerical
figures. The qualitative aspects of the concerned numerals are totally
ignored in the process of ratio analysis. Ignoring qualitative aspect may
mislead the users of ratios. For example, a high current ratio indicates a
satisfactory loan repayment capacity of a firm. But if its current assets
consist of a large quantity of obsolete stock or its debtors are slow paying
the satisfactory trend of loan repayment capacity as indicated by the current
ratio may prove to be only a paper jugglery.
(vii) Ratios indicate trend, do not prove: A common criticism against the
ratio analysis technique is that it only indicates trend but does not prove
anything. By comparing the computed ratios with the ideal or standard
ratios, last years ratios and similar ratios of other firms belonging to the
same industry the inference that is arrived at by the interpreter is nothing
but a trend on any particular event. Whether the trend of the item of
consideration is favourable or unfavourable, satisfactory or unsatisfactory a
general notion as to that can be inferred upon through ratio analysis.
Whether the item is really favourable or unfavourable, satisfactory or
unsatisfactory that can never be authenticated or proved through such
analysis. The considerations that are needed for coming to such a
conclusion decision are not taken care of in ratio analysis. Two reasons
work behind this proposition
that ratios indicate, they do not prove. The first one is that ratios do not
measure numeral or quantities they express the numerical or quantitative
relation in a brief manner. If the ratio of current assets and current
liabilities is 2 : I the amount of current assets and current liabilities may be
Rs. 20,000 and Rs. 10,000 respectively or they may also be Rs. 2,00,000
and Rs. 1,00,000 respectively. The second reason is that for arriving at a
conclusive decision through any technique the same must have the basic
feature of assessing the qualitative aspect along with the aspect of quantity.
(viii) Inclusion of window dressing: The term window dressing stands for
showing the numerical fiLures more than what they are in reality in
financial statements with a fraudulent intention and by means of
manipulation. If an effort is made to exaggerate the values of incomes,
expenses, asset.s and liabilities in the financial statements for the-purpose
of concealing the true and fair financial position of the firm, ratios computed
also reflect the same and do not speak of the real financial scenario. It
indicates that there is every possibility of ratios being biased and influenced
by the window dressing process. Such window dressing may also be made
for showing the ratios higher than what they are in reality with unfair
intention. For example, stock turnover ratio may be exaggerated by deferring
the purchase of inventory or showing the inventory less than the actual
value for showing better managerial efficiency.
(ix) Linkage among different contradictory figures: In case of mixed ratios
one component is taken from the Profit and Loss Account and another from
the Balance Sheet. Again an average of two figures shown in two Balance
Sheets may also be taken as one of the components of a particular ratio. The
numeral shown in the Profit and Loss Account exhibits the outcome of some
events occurred during a particular span of time (generally in one year). On
the other hand the numeral shown in the Balance Sheet indicates the
position of that item on a particular point of time (i.e. on a specific date).
Again the average of two numerals shown in two different Balance Sheets
expresses the average of the positions as on two separate dates. So such
mixed ratios draw up the relationship between the figures having
contradictory status and are not truly comparable.
(x) Problem of use: Computation of a single ratio is in no case sufficient to
analyse any matter. For this purpose a series of ratios need to be calculated.
There is also no hard and fast guideline for using specific ratios for specific
purpose. Selection in most of the cases rests on the choice of the analyst.
Often different analysts use different sets of ratios to analyse the same
matter. Again using of the same ratios for different purposes creates
confusions. That is why it is said that the use of ratios is problematic in
many cases.
(xi) Not effective without cause and effect relationship: The relationship
between those numerals having cause and effect mutual relations between
them can only be expressed through ratios. Numerals without having any
cause and effect relationship are not the subject matter of ratio analysis. For
example, there is no cause and effect relation between the purchase figure
and the provision for taxation. So it is impossible to draw up any
relationship between these two variables through ratio analysis.
(xii) Lack of depth: Ratio analysis is a primary tool used in financial
statement analysis. It is only used to develop a general notion about the
relationship between the related variables or to analyse the trend of the said
relation. As this technique does not assess the qualitative aspect of the
concerned variables it is not possible to make an in-depth assessment
through it. The relationships indicated by ratio analysis need to be further
analysed in-depth through other techniques for making the information
more useful.
(xiii) Ignoring the effect of inflation: The increase in general price level in
the market due to inflationary trend makes the ratio based comparison
futile. The return on fixed assets purchased many years back obviously
becomes more than the return on recently purchased fixed assets.
Apparently looking this difference indicates higher efficiency in the use of
old fixed assets, but in reality that is not the case. The rise in market price
due to inflationary trend may be responsible for such variation, As the effect
of change in market price is ignored ratio analysis on the basis of past data
often creates confusions in the minds of the users and misleads them.