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Ratio analysis, as those used in published accounts, but using internal management accounting data. These ratios should be compared over time (trend analysis) and compared with industry averages or the performance of competitors (benchmarking). Ratios are useful means by which questions could be generated to obtain explanation about trends and relative performance. The statement of income and balance sheet are very important, however they only the beginning point for a successful financial management. Applications of ratios could help the firm to know the success, failure and progress of the business. However there are several limitations of using ratios analysis and they are as follows:
Limitations of Ratio Analysis are as follows:
The analyst should be aware of the limitations in the computations or while doing the ratio analysis.
- Since ratio use financial statement data as inputs, the same factors that cause short-comings in financial statements will affect the ratios computed from item. Such shortcomings, atleast for some purposes, include the use of acquisition cost for asset rather than current replacement cost or net realized value and the latitude firms have in selecting from among various generally accepted principles.
- Changes in many ratios correlate each other. For example, the current ratio and the quick ratio often change proportionally and in the same direction. The analyst need not compute all the ratios to assess a particular dimension of profitability or risk.
- When comparing the size of a ratio between periods for the same firm, the analyst must recognize conditions that have changed between periods being compared (for example, different product lines or geographic markets served, changes in economic conditions, changes in accounting principles and corporate acquisitions.)
- When comparing ratios of a particular firm with those of similar firms, one must recognize differences among the firms (for example, different methods of accounting, different operating methods and different types of financing.)
- What is ratio analysis?
- What are the limitations of ratio analysis?
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