Limitation Of Financial Ratio Analysis

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Financial ratios have been very crucial in understanding the financial conditions of any business form of organization & are commonly used as a tool in calculating & evaluating an organization’s performance. Various studies & research have proven the economic significance & importance of these ratios in analysing the organization’s current efficiency. But the major limitation in using them is that not one ratio can give the overall performance of the organization, we need more than one ratio to estimate the performance. Even if the ratios are good, they may not reflect so in the form of market share prices as they are influenced by many other unknown factors. The objective of this paper is to know more about the ratios used by the majority…show more content…
The figures could represent assets, liabilities, profits, sales, expenses or any other form of items or groups of items which the organization has recorded for its own analysis. Financial ratios constitute hundreds of different ratios, but Indian companies generally categorize these ratios into eight categories – Investment Valuation Ratios, Profitability ratios, Management efficiency ratios, Profit & loss account ratios, Balance sheet ratios, Debt coverage ratios, Leverage ratios & Cash flow indicator ratios. Selection of the right ratios requires thorough understanding of each ratio & its limitations. These ratios are used by Investors, Bankers, Creditors & Internal managers who are interested in the financial analysis of a company. Although they might be using different ratios to analyses the financial strengths & weakness of the company, but what they really would be doing would be a simple inter-firm comparison between the company & the desired output or…show more content…
Brigham & Houston (2009) believed that financial analysis is simply a comparison between the company’s performances to that of other companies in the same sector in order to evaluate the company’s position with time. Firer (1999), & Kelly (2005), have stressed the importance of monitoring the “financial health” of any company using good financial analysis. In financial management, the financial ratios are one of the most structured, strategic & scientific bases for decision making. According to Drake (2010), the financial ratios are one of the tools in financial analysis, used for selection, evaluation, & interpretation of financial data & help in investment & financial decision-making. Financial ratios have been used & acknowledged in the literature for more than 40 years (Horrigan (1965), Edmister (1972), Osteryoung & Constand (1992), Devine & Seaton (1995), or Burson (1998)). Depending on the needs, different class of people use different ratios. For example, shareholders are more concerned with ROSE, ROI, ROE & ROA (R. Thorpe, J. Holloway, 2008). But the problem with using the ratios is that many of the ratios included in the studies are highly correlated with one another. Jackendoff [25], Elam [21] & Deakin [8] conducted some experiments which proved this observation. Therefore, there was
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