## Ratio Analysis: Meaning, Advantages and Limitations

If there was an unusual spike or decline in the on the last day of the reporting period, this can impact the outcome of the ratio analysis. Useful in Comparison of Performance: Through accounting ratios comparison can be made between one departments of a firm with another of the same firm in order to evaluate the performance of various departments in the firm. Vertical Analysis Vertical analysis is conducted on financial statements for a single time period only. An example is a company that uses First in, First Out method to value its inventory will have a higher inventory value compared to the company that uses Last in, First Out method. They use financial statement analysis to determine what to do with their investments in the company.

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## What are the disadvantages and advantages of a financial statement analysis?

The debt-to equity ratio relates the amount of debt taken on by a company to its equity. A firm records of its fixed, long-term assets every year. It tells a share buyer what earnings can be expected from the share in the form of higher dividends or higher share price at the time of sale. The main advantage of this ratio is that it figures out if there is a problem in the basic operations of the company. That is, it helps to understand the strength or weakness of a particular firm in comparison with other related firm in the industry. Trend analysis Trend analyses describe changes that have occurred from one period to the next. This metric cannot be compared with companies that belong to different industries.

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As financial statements are prepared in order to meet requirements, the second step in the process is to analyze them effectively so that future profitability and cash flows can be forecasted. The means include the , asset utilization and financial leverage also known as financial gearing. For the whole process of financial and accounting ratio analysis to make sense, provisions have to be made to account for these macro variables. Limitations of Financial Statements: Ratios are calculated from the information recorded in the financial statements. Whenever you deal with profitability ratios, you always think of profits as a percentage of something. For example, if a company records an expense in one period as , while in another period, it is recorded as a selling and distribution expense, the analysis between those two periods would not be comparable. To make ratio analysis mean something, different industry averages need to be used for each different division.

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Advantages and Disadvantages of Vertical Analysis Vertical analysis only requires financial statements for a single reporting period. The total liabilities could be found in the balance sheet or you can substrate the total equity from total assets to figure out total liabilities. Internal users refer to the management of the company who analyzes financial statements in order to make decisions related to the operations of the company. Unless you try to find the cause of the numbers you come up with, you are playing a useless game. Historical Information: Financial statements provide historical information. Disadvantages of Profitability Ratios Like nothing in the world is free of drawbacks, profitability ratios are not an exception. This does not help in finding the actual cause of this and what corrective actions need to be taken.

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Inventory valuation methods may differ and so can depreciation methods. Window dressing is in no way an accepted practice but many companies do indulge in such malpractices to give a false impression to their investors. But it is very difficult to select such a base year for the propose of ascertaining the trend. Long-term Assets Long-term assets are also called non-current assets and include fixed assets like plant, equipment and machinery, and property, etc. An extremely high ratio, for example, may indicate that profits have probably been overstated and that a fall in share price may be round the corner.

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## The Advantages of Financial Ratios

Efficient and effective utilization of assets has a direct impact on profitability. Such factors are so significant that a comparison of two companies from different industries might be misleading. Generally, ratio analysis involves four steps: i Collection of relevant accounting data from financial statements. Conversely, a company in the same industry is focusing on a high customer service strategy where its prices are higher and gross margins are higher, but it will never attain the levels of the first company. For example, expenses as a percentage of sales can be easily forecasted on the basis of sales and expenses of the past years.

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## What are some of the advantages and disadvantages of DuPont Analysis?

Fundamental analysis is the term given to the use of financial ratios in determining the relative strength of companies for investing purposes. Horizontal analysis can also be used to misrepresent results. Profitability ratio as one of the categories has subcategories. The Balance Sheet Â© Wikimedia Commons The shows the current financial position of the firm, at a given single point in time. As an example, analysis may reveal that the average debt-to-equity ratio in the widget industry is. Creditors Creditors are interested in knowing if a company will be able to honor its payments as they become due. Useful in Forecasting Purposes 5.

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