M.COM. SEMESTER - II (CBCS)
CORPORATE FINANCE
Q.8. ADVANTAGES
OF RATIO ANALYSIS AND LIMITATIONS OF RATIO ANALYSIS
ANS:
ADVANTAGES
OF RATIO ANALYSIS
Advantages
of ratio analysis for shareholders and prospective investors;
1.
Shareholders and prospective investors will analyse ratios for making decisions
regarding investment and disinvestment.
2. The
credit rating agencies will analyse the ratios of a firm to give the credit
rating to the firm.
3.
Government agencies will analyse the ratios of a firm for review of its performance.
4. Bankers
who provide working capital will analyse ratios for appraising the
creditworthiness of the firm.
5. Financial
institutions that provide long-term debt will analyse ratios for project
appraisal and debt servicing capacity of the firm.
6. Financial
analysts will analyse ratios for making comparisons and recommending to the
investing public.
LIMITATIONS
OF RATIO ANALYSIS
The
following limitations of ratio analysis must be taken into account:
1. Over-use
of ratios as controls on managers could be dangerous; in the management might
concentrate more or simply improving the ratio that one dealing with the
significant issues.
2. Ratios
can only provide guidelines to the management. They are only the means.
However, they scratch surfaces and raise questions. This limitation of ratios
may force the management to have detailed investigation of the situation under
question.
3. The
standards will differ from industry to industry. Comparison of ratios of firms
belonging to different industries is not suggested.
4. Since
ratios are calculated from past records, there are no indicators of the future.
5. Proper
care should be exercised to study only such figures as have a cause and effect
relationship, otherwise, ratios will only be meaningless or misleading.
6. The
reliability and significance attached to ratios depends on the accuracy of data
based on which ratios are calculated.
7. Ratios of
a company can have meaning only when they are compared against standard. Past
performance of the same company cannot be benchmarked when there is change in circumstances.
8. The
change in price levels due to inflation will distort the reliability of ratio
analysis.
9. The
analyst should have through knowledge of methods of window-dressing.
10.Single
accounting ratio is not useful at all, unless it is studied with other
accounting ratios. This limitation of ratios necessitates inter-firm and
intra-firm comparisons.
11.Ratios
are based only on the quantitative information. Hence, qualitative information
(i.e. character, managerial ability etc.) places a limit on the ratios.
12.Ratios
are subject to arithmetical accuracy of the financial statements. Moreover,
financial statements also include estimated data like provision for
depreciation, for bad and doubtful debts, etc. Hence, results revealed by
ratios are subject to such estimates.
13.Ratios
are computed on the basis of financial statements which are historical in
nature.
14.Knowledge
of ratios alone in meaningless unless their composition is also ascertained.
15.Lack of
homogeneity of data, personal judgment, lack of consistency, etc. is the
factors that limit the conclusion to be derived on the basis of accounting
ratios.
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