Limitations to Ratio Analysis

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Limitations to Ratio Analysis

There are many different groups of people (or stakeholders) who are interested in the accounts of a company, including:

  1. The management and the employees - to see if pay rises are likely, or to ensure that their jobs are secure.
  2. Creditors - to ensure that the business has the necessary money to repay them.
  3. Potential lenders - to see if the business is solvent and profitable enough to repay any loans.
  4. The community - to ensure that jobs and services for the local community are assured.

Using financial ratios can assist these people in identifying the financial strengths and weaknesses of a company, as well as indicating to the company itself those areas that need corrective action.

However, ratio analysis does not provide a complete and exhaustive analysis of a company, and there are several other factors that the stakeholders and the company will need to take into account, in order to get the 'full picture' of its financial position:

  • The state of the economy (i.e. if the economy is in a recession, then the ratios are more likely to be unsatisfactory than if the economy is experiencing a 'boom').
  • The performance of competitors (i.e. it may be the case that the industry is in decline, in which case all the rival businesses are likely to be experiencing deteriorating ratios).
  • Comparison year on year, The ratios for the business from the current year must be compared to the ratios from previous years, in order to see any marked improvement or deterioration in the financial performance.
  • External factors. The financial ratios do not take into consideration any effects on the local community or the environment (i.e. they ignore the effects of pollution, job losses, etc). Therefore, in order to measure the performance of a business, factors other than mere financial ratios need to be considered.

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