What are the merits and demerits of ratio analysis?

Answer 1

Financial ratio analysis is a useful tool for users of financial statement. It has following advantages:

Advantages

• It simplifies the financial statements.
• It helps in comparing companies of different size with each other.
• It helps in trend analysis which involves comparing a single company over a period.
• It highlights important information in simple form quickly. A user can judge a company by just looking at few numbers instead of reading the whole financial statements.

LimitationsDespite usefulness, financial ratio analysis has some disadvantages. Some key demerits of financial ratio analysis are:

• Different companies operate in different industries each having different environmental conditions such as regulation, market structure, etc. Such factors are so significant that a comparison of two companies from different industries might be misleading.
• Financial accounting information is affected by estimates and assumptions. Accounting standards allow different accounting policies, which impairs comparability and hence ratio analysis is less useful in such situations.
• Ratio analysis explains relationships between past information while users are more concerned about current and future information.