What Is Ratio Analysis? What Are Its Limitations?

Accounting ratios attempt to highlight relationships between significant items in the accounts of a firm. By calculating ratios, we can assess the profitability, efficiency, and solvency of the firms. Areas of concern can be highlighted and decision-making can be improved. There are five groups of accounting ratios:

Profitability ratios relate profits to sales and assets. Liquidity ratios show the extent to which the firm can meet its financial obligations.

Efficiency ratios indicate how active a firm has been. Gearing ratios show the balance between equity and loan finance.

Shareholders or investment ratios are a measure of the return on investments.

Ratios are a useful tool of analysis but should always be used with caution.

First, we should always remember the accounting conventions and procedures by which various values were arrived at. The fact is that most accounting information lacks precision.

Second, although ratios are useful in making comparisons over time, we should bear in mind the effects of inflation and changes in both conditions and methods of calculation.

Third, when ratios are used for inter-firm comparisons we must bear in mind differences between the product mixes of firms and accounting methods used.

Fourth, ratios highlight problems, but other non-quantitative information should also be taken in to account.

However, ratios are more useful in depicting trends over time than in isolation.

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