2.6 Uses and limitations of Ratio Analysis 2.6.1 Uses
· To evaluate performance (compared to previous years);
· To set benchmarks or standards for performance;
· To highlight areas those need to be improved or highlight
areas that offer the most promising future potential;
· To enable external parties (such as investors/lenders) in
assessing the creditworthiness/profitability of the firm.
2.6.2 Limitations
· There is considerable subjectivity involved as there
is no theory as to what should be the «right» number for the various
ratios. Further, it is hard to reach a definite conclusion when some of the
ratios are favourable and some are unfavourable.
· Ratios may not be strictly comparable for different firms
due to a variety of factors such as different accounting practices, different
fiscal year.
· Ratios are based on financial statements that reflect the
past and not the future. Unless the ratios are stable, one cannot make
reasonable projections about the future trend.
· Financial statements provide an assessment of the
costs and not value. For example, the market value of items may be very
different from the cost figure given in the balance sheet.
· Financial statements do not include all items. For
example, it is hard to put a value on human capital (such as management
expertise).
· Accounting standards and practices vary across countries
and thus hamper meaningful global comparisons.
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