Significance limitation of ratio analysis

Advantages and Limitations of Ratio Analysis Financial ratio analysis is a useful tool for users of financial statement. It has following advantages: Advantages It simplifies the financial statements. It helps in comparing companies of different size with each other.

Significance limitation of ratio analysis

Your are required to compute current ratio of the company. Significance and interpretation Current ratio is a useful test of the short-term-debt paying ability of any business. A ratio of 2: Simply computing the ratio does not disclose the true liquidity of the business because a high current ratio may not always be a green signal.

It requires a deep analysis of the nature of individual current assets and current liabilities. A company with high current ratio may not always be able to pay its current liabilities as they become due if a large portion of its current assets consists of slow moving or obsolete inventories.

On the other hand, a company with low current ratio may be able to pay its current obligations as they become due if a large portion of its current assets consists of highly liquid assets i. Consider the following example to understand how the composition and nature of individual current assets can differentiate the liquidity position of two companies having same current ratio figure.

Example 2 The following data has been extracted from the financial statements of two companies — company A and company B. Both company A and company B have the same current ratio 2: Do both the companies have equal ability to pay its short-term obligations? The answer is no.

Significance limitation of ratio analysis

Company B is likely to have difficulties in paying its short-term obligations because most of its current assets consist of inventory. Inventory is not quickly convertible into cash.

Limitations

The company A is likely to pay its current obligations as they become due because a large portion of its current assets consists of cash and accounts receivables. Accounts receivables are highly liquid and can be converted into cash quickly.

From this analysis, it is clear that the analyst should not only see the current ratio but also the composition of current assets. Limitations of current ratio Current ratio suffers from a number of limitations. Some are given below: Different ratio in different parts of the year: Some businesses have different trading activities in different seasons.

Such businesses may show low current ratio in some months of the year and high in others.

Significance limitation of ratio analysis

Change in inventory valuation method: To compare the ratio of two companies it is necessary that both the companies use same inventory valuation method. For example, comparing current ratio of two companies would be like comparing apples with oranges if one uses FIFO cost flow assumption and the other uses LIFO cost flow assumption for the valuation of inventories.Ratio analysis is the process of determining and interpreting numerical relationships based on financial statements.

A ratio is a statistical yardstick that provides a measure of the relationship between two variables or figures. Ratio analysis is the process of determining and interpreting numerical relationships based on financial statements. A ratio is a statistical yardstick that provides a measure of the relationship between two variables or figures.

Limitations of ratio analysis 1. Limited use of Single Ratio. A single ratio cannot convey any meaning at all. Hence, some more ratios are calculated to know something from a single ratio. Ratio analysis is a cornerstone of fundamental analysis.

Qualitative Factors are Ignored:

The various ratios are standardized, elegant and convenient to use. Ratio analysis helps us to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency.

Current ratio (also known as working capital ratio) is a popular tool to evaluate short-term solvency position of a business. Short-term solvency refers to the ability of a business to pay its short-term obligations when they become due.

Therefore, to it, the Ratio between Turnover to Capital Employed, Turnover to Fixed Assets, Turnover to Current Assets, Stock-Turnover Ratio, Debtors’ Turnover Ratio, Creditors’ Turnover Ratio etc.

are of significance to the management.

Ratio Analysis: Meaning, Classification and Limitation of Ratio Analysis