Advantages and disadvantages of using ratios in financial analysis
Advantages
Financial ratios help in presenting the financial statements in a simplified manner. When determining the value of the company, it is easy to use ratios to understand the financial statements of a firm since one can understand the reasons and premise for the basic analysis. The ratios are mathematical indicators which are calculated through comparison of significant financial information in the statements (Wahlen, Bradshaw & Baginski, 2014).
On that note, ratios are useful in financial analysis because it makes it possible to compare financial information and position of two or more companies in the simplified way. Directly comparing financial statements is inefficient since the business are normally no of the same size. By using ratios, one is able to compare the statements of different firms and even across varying periods of one firm. Moreover, one can analyze different aspects of the financial position using separate ratios (Wahlen, Bradshaw & Baginski, 2014).
Disadvantages
A financial analysis that uses ratios does not consider outside factors that affect the performance of the company. This means that the analysis is usually not exhaustive since there are various factors that any firm will have to consider so as to get the complete view of the financial position (Wahlen, Bradshaw & Baginski, 2014). For instance, ratio analysis does not consider the effect of economic status, whether its boom or recession; competitors performance where a decline in the industry is likely to lead to poor rations and other factors such as job losses.
Information used in ratio analysis is normally gotten from the historical results, and historical results do not necessary get carried forward. The information contained in income statements is current while other aspects of balance sheet are historically stated and this variance may lead to abnormal ratio results (Wahlen, Bradshaw & Baginski, 2014).
Reference
Wahlen, J. M., Bradshaw, M. T., & Baginski, S. P. (2014). Financial reporting, financial statement analysis, and valuation. 295
