Advantages And Disadvantages Of Ratio Analysis UGC Exam Notes (2024)


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Ratio analysis is a powerful tool. It is used by firms to evaluate their financial performance. It helps to identify trends and make informed decisions. Ratio analysis has several advantages, there are also some drawbacks to consider. This method enables firms and investors to understand the extent of a firm's growth. It helps in identifying operational issues. It empowers management to take corrective actions. While taking informed financial decisions. This method is widely recognized and greatly benefits firms.

Advantages and disadvantages of ratio analysis are of great importance to students preparing for the UGC NET exam. As it is a frequently tested topic in the Commerce papers.

In this article, we will explore both the advantages and disadvantages of ratio analysis.. Whether you're a small firm proprietor or a financial analyst. This article will furnish valuable insights into ratio analysis.

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Ratio Analysis

Ratio analysis is a method used to examine a firm's financial statements. Likewise Profit and Loss Account, Balance Sheet, and Fund Flow statement. When used correctly, ratio analysis can help identify problems and positive things in a firm. Ratios are like whistleblowers, they draw attention to issues that need attention.

This is important for management to improve the firm's performance. Ratio analysis is a popular way to study a firm's financial health. It helps shareholders, investors, creditors, government officials, and analysts to understand financial statements better. It is like a doctor checking blood pressure, pulse rate, and body temperature to know a patient's health. Similarly, financial analysts use accounting ratios to diagnose the financial health of a firm.

Ratio analysis involves multiple financial ratios such as liquidity, profitability, solvency, and efficiency ratios, each offering distinctive insights into a firm's financial performance and highlighting areas of strength and vulnerability. Although ratio analysis can be valuable in assessing a firm's financial health, there are some limitations of ratio analysis. For instance, ratio analysis relies on past financial data and may not feel the impact of future changes in the market or a firm's operations.

Moreover, firms may use accounting practices to work their financial ratios, highlighting the advantages and disadvantages of ratio analysis alongside other financial metrics and qualitative information.

Read about types of ratio analysis, here.

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Objectives of Ratio Analysis

Ratio analysis is a financial analysis method used to evaluate a firm's financial performance and health by examining affinities between various financial variables. The objectives of ratio analysis include:

  • Performance Assessment: Ratio analysis helps in assessing the overall financial performance of a firm. By comparing various financial ratios over time or against industry benchmarks, stakeholders can determine if the firm is improving, deteriorating, or maintaining its financial performance.
  • Profitability Analysis: Ratios like the net profit margin, return on assets (ROA), and return on equity (ROE) provide insights into a firm's profitability. These ratios help assess how effectively a firm is generating profits from its operations and assets.
  • Liquidity Assessment: Liquidity ratios such as the current ratio and quick ratio assess a firm's ability to meet its short-term obligations. These ratios are essential for creditors and suppliers to evaluate whether a firm can pay its bills on time.
  • Solvency and Financial Health: Ratios like the debt-to-equity ratio and interest coverage ratio evaluate a firm's solvency and financial stability. They help creditors and investors gauge the firm's ability to meet its long-term debt obligations and avoid financial distress.
  • Operational Efficiency: Efficiency ratios, such as inventory turnover, accounts receivable turnover, and asset turnover, help gauge how efficiently a firm is using its resources and managing its working capital.
  • Investor Decision Making: Investors use ratio analysis to make informed investment decisions. By analyzing a firm's financial ratios, investors can assess the firm's financial health, growth prospect, and risk profile.
  • Creditworthiness Evaluation: Lenders and creditors use ratio analysis to assess the creditworthiness of a firm before extending loans or credit lines. They evaluate whether the firm can generate sufficient cash flows to service its debt.
  • Benchmarking: Ratios allow a firm to benchmark its performance against industry peers or rivals. This helps identify areas where the firm may be lagging behind or excelling relative to others in the same industry.
  • Financial Planning: Ratio analysis assists in financial planning and forecasting. By analyzing historical financial data, a firm can make more exact projections for future financial performance and make informed budgeting decisions.
  • Identifying Trends and Anomalies: Ratio analysis helps in identifying trends and anomalies in a firm's financial statements. Sudden or unusual changes in ratios can signal financial crises or options that require further investigation.
  • Management Evaluation: Ratio analysis can be used to evaluate the effectiveness of a firm's management. Always improving ratios may indicate good management practices, while deteriorating ratios could signal management issues.
  • Risk Assessment: Financial ratios also play a crucial role in risk assessment. They help stakeholders apprehend the financial risks associated with the firm, which is vital for making risk management decisions.

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Advantages Of Ratio Analysis

Ratio analysis is a powerful tool employed by enterprises and financiers to scrutinise the monetary well-being of a corporation. Companies can gain insights into their financial performance, profitability, and liquidity by analysing various financial ratios. In this part of the article, we will discuss the advantages of ratio analysis.

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Inventory turnover and sales turnover ratios demonstrate. Firm efficiency in utilizing its resources to generate sales or utilize inventory. A high ratio indicates good efficiency. While a decreasing ratio may indicate a buildup of inventory, outdated products, or ineffective marketing.


These numbers tell us if a firm has enough aids to pay its bills now and later. Big firms like S&P and Moody's check these numbers to decide if investing in a firm is safe. We look at other numbers. Like how much money the firm has and how fast they can access it if needed.


The liquidity ratio is how much money a firm has in cash and near-cash things. It helps to see if the firm can get money fast for something unexpected. But if a firm has too much money in these things, it might not get more money from other investments. So, it's best for a firm to have the right amount of liquidity.

Market Performance

Ratios like P/E ratio, P/Sales ratio, P/BV ratio, EV/EBITDA help us know if a firm is worth more or less than similar firms. They also help investors decide if they should buy the stock based on the level of risk. Management can also use these ratios to apprehend how the firm's performance affects the share price and decide on future plans.


Ratios like Gross Profit Margin, Net Profit Margin, Return on Equity help understand if investing in a firm is good or not. If Net Profit Margin is low and Gross Profit Margin is high, it means the firm spends a lot and needs to fix this.


When the people in charge see the numbers, they can make plans for what to do next. They might decide to spend money on growing their firm or think about renting instead of buying things. They also think about what might happen in the future and make a plan for how to make the firm bigger over time.


When a store sells things quickly, it's good for them. They can order a lot at once and save money. This is because they won't need to order again for a while. It's like buying in bulk. It's the same for other expenses like paying for rent or electricity. The store can plan how much they need to spend. According to how much they sell. This helps them make sure they have enough money.

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Disadvantages Of Ratio Analysis

Although ratio analysis has several advantages, it is crucial to acknowledge that its use presents limitations and potential drawbacks. In this part of the article, we will discuss the disadvantages of ratio analysis.

Limited scope

Ratio analysis focuses exclusively on financial ratios and does not consider non-financial elements. For example, a firm with high financial ratios may still struggle with customer satisfaction, employee morale, and brand image. Hence, a comprehensive assessment of a firm's overall health requires considering financial and non-financial variables.

Incomplete comparison

Comparing financial ratios across various industries and firms may not be equitable, as distinct industries and firms possess unique financial and operating features. For instance, a favourable high inventory turnover ratio in retail may not hold for manufacturing. Therefore, careful interpretation of ratios is required, viewing the specific traits of the industry and the firm under analysis.

Historical data

Ratio analysis relies on historical financial data. Financial ratios are computed based on previous performances, which may not be a dependable tool for forecasting future financial trends and performances.

Furthermore, a firm's financial performance can be affected by various external factors, such as alterations in market conditions, economic factors, or other influences that may not be captured in historical financial data.


Bookkeeping techniques can manipulate financial metrics, such as overly optimistic revenue recognition or inflating the value of firm assets. For instance, a corporation might decrease its inventory levels temporarily at the end of a quarter to enhance its present ratio. As a result, it is imperative to scrutinise the financial reports closely to ascertain that the metrics are not artificially augmented.

Inaccurate assumptions

Ratio analysis is based on certain beliefs about the accuracy of financial statements, the uniformity of accounting procedures, and the comparability of financial statistics.

Nevertheless, these assumptions may not be invariably valid. The financial statements may contain inaccuracies or exclusions, the accounting practices may differ among trades and entities, and the financial data may not be promptly similar because of disparities in reporting protocols or accounting doctrines.

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Limitations Of Ratio Analysis

Ratio study means a valuable mechanism for setting a firm's fiscal performance. However, there are limitations to the use of ratio analysis that should be regarded when interpreting financial statements. In this part of the article, we will discuss the limitations of ratio analysis in detail.

Historical Data

Ratio analysis, predicated upon past financial data, may not provide a reliable predictor of future performance. Economic factors like market fluctuations and sundry external variables can greatly impact a firm's fiscal performance beyond what can be inferred from prior financial data.

Industry and Company Differences

Comparing financial metrics and ratios between various industries and firms may yield a vague and lying comparison. Each firm and industry has unique financial and operational factors affecting the ratios. Consider, for instance, that a utility firm may tolerate a high debt-to-equity ratio, yet such a proportion would be inappropriate for a software firm.

Financial Statement Quality

The accuracy and thoroughness of financial statements are critical in computing reliable financial ratios. Inaccuracies, omissions, or manipulations in financial statements can result in misleading ratio calculations.

Limited Information

Ratio analysis provides a limited view of a company's financial performance. It only focuses on financial ratios and does not consider non-financial factors such as customer satisfaction, employee morale, and brand image.

Accounting Methods

Different accounting methods can impact the calculation of financial ratios. For example, using the LIFO (Last-In, First-Out) inventory valuation method can result in other inventory turnover ratios than the FIFO (First-In, First-Out) method.


Inflation can distort financial ratios, mainly those that pertain to the valuation of assets and liabilities. Inflation has the potential to result in an understated depreciation expense of fixed assets, leading to an overstated return on assets ratio.

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Ratio analysis provides valuable insights into a firm's financial performance. The benefits of ratio analysis can help identify trends, evaluate solvency and liquidity, assess profitability, and simplify comparisons over time and with peer firms within the same industry. However, it is essential to consider the advantages and limitations of ratio analysis, including reliance on past data, variances in accounting practices, the possibility of mistakes in financial statements, and the failure to consider non-financial factors. Therefore, while advantages and disadvantages of ratio analysis presents a useful technique for financial evaluation. It should be used in conjunction with other methods to obtain a more complete learning of a firm's financial well-being.

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Advantages And Disadvantages Of Ratio Analysis FAQs

What are the advantages of ratio analysis?

Ratio analysis confers several advantageous attributes, such as providing lucid and comprehensible financial data, a prompt and efficient methodology for identifying possible issues, a beneficial instrument for making decisions, and an effective technique for contrasting a corporation's performance to that of its counterparts in the industry.

What are the disadvantages of ratio analysis?

Some disadvantages of ratio analysis include its reliance on historical data, limited comparability across companies and industries, potential distortion from accounting policies, and a narrow focus on quantitative metrics without considering qualitative factors.

What are liquidity ratios, and why are they important?

Financial ratios measuring a company's short-term liquidity, known as liquidity ratios, carry significant weight in assessing its solvency. The ratios offer valuable insights into a company's ability to settle its debts and meet its financial obligations as they become due.

What common financial ratios are used in ratio analysis?

Solvency ratios are essential for assessing a company's long-term solvency. These ratios provide valuable insight into a company's capacity to pay off its debts and maintain operations for an extended period. As such, they are critical for investors and creditors to evaluate a company's financial health and make informed decisions about investments or lending.

How can a company use ratio analysis to improve its financial performance?

A corporation can employ ratio analysis to identify segments of its financial performance that require rectification, including inadequate profitability, immense debt levels, or inefficient use of its assets. By comprehending its areas of expertise and drawbacks, a company can provide schemes to enhance its fiscal performance, such as executing cost-cutting methods, restructuring its debt, or optimizing its assets.

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