Ratio Analysis: Definition and Limitations | Cost Accountancy

In this article we will discuss about Ratio Analysis:- 1. Definition of Ratio Analysis 2. Limitations of Ratio Analysis.

Definition of Ratio Analysis:

Ratio Analysis is a powerful tool of financial analysis. A ratio is defined as “the indicated quotient of two mathematical expressions and as the relationship between two or mm thing?” — Webster’s New Collegiate Dictionary.

Ratio Analysis may be defined as the systematic use of ratio to interpret the financial statements so that the strength and weaknesses of a firm as well as its historical performance and current financial condition can be determined.

The term ‘ratio’ refers to the numerical or quantitative relationship between two items or variables.

In financial analysis, a ratio is used as an index or yardstick for evaluating the financial position and performance of a firm. As a matter of fact, an accounting figure conveys meaning when it is related to some other relevant information. Therefore, ratios help to summaries the large quantities of financial data and to make qualitative judgement about firm’s financial performance and financial position.

The accounting ratios serve many purpose, they can assist management in its basic functions like forecasting, planning, co-ordination, control, and communication. If they are used properly they can improve efficiency and therefore, profits.

Limitations of Ratio Analysis:

“The ratio analysis is an aid to management in taking credit decisions, but as a mechanical substitute for thinking and judgement, it is worse than useless.” —Hunt, Williams & Donaldson

Though ratios are precious tools in the hands of the analyst but its significance emanates from proper use of these ratios. Misuse and mishandling of the ratios may lead the management and other users to a wrong decisions.

There are some limiting factors for the use of ratios.

These limiting factors are as follows:

(i) Ratios are not end in themselves but they are means to achieve a particular end.

(ii) The accuracy and correctness of ratios are totally dependent upon the reliability of the data contained in financial statements on the basis of which ratios are calculated.

(iii) The analyst or the user must have comprehensive but practical knowledge and experience about the concerns whose statements are used for calculating ratios.

(iv) In case of inter-firm comparison, there must be uniformity in the accounting plan used by both the firms.

(v) Ratios may make the comparative study complicated and misleading on account of changes in price level.

(vi) Inter-firm comparison through ratio analysis should not be undertaken in the case of concerns which are not associated or comparable.

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