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DEMERITS OF RATIO ANALYSIS

Discuss DEMERITS OF RATIO ANALYSIS within the Financial Management ( FM ) forums, part of the Resolve Your Query - Get Help and discuss Projects category; DEMERITS OF RATIO ANALYSIS Accounting ratios are subject to certain limitations. They are: 1. Comparative study required: Ratios are useful ...

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DEMERITS OF RATIO ANALYSIS
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Abhijeet S
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DEMERITS OF RATIO ANALYSIS - September 23rd, 2010

DEMERITS OF RATIO ANALYSIS


Accounting ratios are subject to certain limitations. They are:


1. Comparative study required: Ratios are useful in judging the efficiency of business only when they are compared with the past results of the business or with the result of a similar business. Such comparison only provides a glimpse of the past performance and forecasts for future may not prove correct since several other factors like market conditions etc may affect the future operations.


2. Limitations of financial statements: Ratios are based only on the information which has been recorded in the financial statements. For example: non-financial changes though important for the business are not revealed by the financial statements. Of the management of the company changes, it may have ultimately adverse effects on the future profitability of the company but this cannot be judged by having a glance at the financial statements of the company.


3. Ratios alone are not adequate: Ratios are only indicators; they cannot be taken as final regarding good or bad financial position of the business. “Ratios must be used for what they are financial tools.” Too often they are looked upon as ends in themselves rather than as a means to an end. The value of a ratio should not be regarded as good or bad inter se.


4. Window dressing: The term window dressing means manipulation of accounts in a way so as to conceal vital facts and present the financial statements in a way to show a better position than what it actually is. On account of such a situation, presence of particular ratio may not a definite indicator of good or bad management.


5. Problems of price level changes: Financial analysis based on accounting ratios will give misleading results if the effects of changes in price level are not taken into account. The financial statements of the companies should, therefore, be adjusted keeping in view the price level changes if a meaningful comparison is to be made through accounting ratio.


6. No fixed standards: No fixed standards can be laid down for ideal ratios. For example: current ratios are considered to be ideal if the current assets are twice the current liabilities. It is necessary to avoid many rules of thumb. Financial analysis is an individual matter and value for a ratio which is perfectly acceptable for one company or one industry may not be at all acceptable in case of another.


7. Ratios are composite of many figures: Ratios are a composite of many different figures. Some cover a time period, other are at an instant of time while still others are only averages. It has been said that “a man who has his head in the oven and his feet in the icebox is on the average, comfortable”!



It may therefore be concluded that “The ratio analysis is an aid to management in taking credit decisions, but as a mechanical substitute for thinking and judgment, it is worse than useless. The ratios if discriminately calculated and wisely interpreted can be a useful tool of financial analysis.”
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Re: DEMERITS OF RATIO ANALYSIS - October 11th, 2012

thank u very much for all the inputsss Keep the good work going
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Re: DEMERITS OF RATIO ANALYSIS - October 11th, 2012

Good Collection of Demerits.
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Business Education
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Re: DEMERITS OF RATIO ANALYSIS - June 15th, 2015

Advantages of Ratio Analysis
  1. It simplifies the financial statements.
  2. It helps in comparing companies of different size with each other.
  3. It helps in trend analysis
  4. It highlights important information in simple form quickly.
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Rose Marry
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Re: DEMERITS OF RATIO ANALYSIS - April 21st, 2016

Quote:
Originally Posted by abhishreshthaa View Post
DEMERITS OF RATIO ANALYSIS


Accounting ratios are subject to certain limitations. They are:


1. Comparative study required: Ratios are useful in judging the efficiency of business only when they are compared with the past results of the business or with the result of a similar business. Such comparison only provides a glimpse of the past performance and forecasts for future may not prove correct since several other factors like market conditions etc may affect the future operations.


2. Limitations of financial statements: Ratios are based only on the information which has been recorded in the financial statements. For example: non-financial changes though important for the business are not revealed by the financial statements. Of the management of the company changes, it may have ultimately adverse effects on the future profitability of the company but this cannot be judged by having a glance at the financial statements of the company.


3. Ratios alone are not adequate: Ratios are only indicators; they cannot be taken as final regarding good or bad financial position of the business. “Ratios must be used for what they are financial tools.” Too often they are looked upon as ends in themselves rather than as a means to an end. The value of a ratio should not be regarded as good or bad inter se.


4. Window dressing: The term window dressing means manipulation of accounts in a way so as to conceal vital facts and present the financial statements in a way to show a better position than what it actually is. On account of such a situation, presence of particular ratio may not a definite indicator of good or bad management.


5. Problems of price level changes: Financial analysis based on accounting ratios will give misleading results if the effects of changes in price level are not taken into account. The financial statements of the companies should, therefore, be adjusted keeping in view the price level changes if a meaningful comparison is to be made through accounting ratio.


6. No fixed standards: No fixed standards can be laid down for ideal ratios. For example: current ratios are considered to be ideal if the current assets are twice the current liabilities. It is necessary to avoid many rules of thumb. Financial analysis is an individual matter and value for a ratio which is perfectly acceptable for one company or one industry may not be at all acceptable in case of another.


7. Ratios are composite of many figures: Ratios are a composite of many different figures. Some cover a time period, other are at an instant of time while still others are only averages. It has been said that “a man who has his head in the oven and his feet in the icebox is on the average, comfortable”!



It may therefore be concluded that “The ratio analysis is an aid to management in taking credit decisions, but as a mechanical substitute for thinking and judgment, it is worse than useless. The ratios if discriminately calculated and wisely interpreted can be a useful tool of financial analysis.”
Hi abhi,

Here I am up-loading Ratio Analysis - Applications Limitations and Dangers, please check attachment below.
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