Understanding the Limitations of Financial Ratio

Question: Discuss financial ratio analysis. Identify two advantages and two disadvantages to using ratios in financial analysis. Answer: The two advantages of using ratio analysis are: Projection of the firms ability Financial ratios help in shedding light on the skills of the firm to meet the obligations. Moreover, from the financial ratios, the position of the business can be known (Northington, 2011). These ratios can be compared with the past or the rivals ratio to know the position of the company. Moreover, accountants, as well as analysts to predict the variables use the ratios. Predictive purpose The company and the management to ascertain the empirical relationship can use financial ratios. This is done by comparing the computed ratios with the pre-determined ones. In short, it provides guidance on the fact that where the business will stand in the future (Spiceland et. al, 2011). The two disadvantage of using ratio analysis are: Inconsistent techniques Financial ratios are determined by the accounting principles and classifications. However, such choices might not be correct and consistent. Hence, comparability is compromised. There is a strong availability of choices and hence, declines the chances of comparability (Joseph, 2015). Different companies might choose a different method of analysis and hence, difference might occur. Problem with numerator and denominator If either of the numerator or denominator is misstated then the financial ratio will project an error. There might be a human error, or there might be an error in the collection of data leading to issues. Moreover, when manipulating accruals are used it might lead to error and hence interpretation will be affected (Joseph, 2015). References Joseph F. (2015). Understanding the Limitations of financial ratio. Academy of Accounting and Financial Studies Journal, 19(3), 75-81 Northington, S. (2011).Finance. New York, NY: Ferguson's. Spiceland, J., Thomas, W. and Herrmann, D. (2011). Financial accounting. New York: McGraw-Hill/Irwin, University Press