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.