What are importance and limitations of financial ratios?

Importance of financial ratios is as follows −

  • By analysing and inspecting the previous results, ratio analysis can relate between different items.

  • Ratio analysis can be used to prepare budget, can formulate policies and also used to plan future.

  • Ratio analysis tells whether the firm is improving or not.

  • Ratio analysis act as surveyor of efficiency.

  • Inter firm comparison can be made.

  • Tells about short term liquidity position.

  • Long term solvency can be measured.

  • With the help of ratio analysis, investors can analyse company’s financial statements to their interest.

  • Determines profitability of a company.

  • Operational efficiency can be analysed.

  • Helps in understanding the business and financial risks of a company.

Advantages of ratio analysis are as follows

  • By comparing to its competitors, ratio analysis tells about area of improvements by formulating its strategies.

  • Ratio analysis will check on excessive debt accumulation of a company.

  • It helps companies to define its limit.

  • By using ratio analysis companies can check on its internal and externals by calculating required terms.

Disadvantages of ratio analysis are as follows

  • Comparison is very difficult.
  • It is not a standard method to calculate.
  • It can be manipulated by accounting practices.

Limitations of ratio analysis are mentioned below

  • Results are compared between companies from similar industries.
  • It ignores price change due to inflation.
  • It ignores qualitative aspects.