Business Finance - Limitations Of Ratio Analysis

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  • Created by: Emma Rudd
  • Created on: 25-03-08 16:29
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Ratios ­ Text Book
Limitations of Ratio Analysis
Ratio analysis provides stakeholders with an insight into the performance of a business.
However to offer the maximum amount of information, the details gained from ratio
analysis need to be compared with other data, such as;
The Results for the Same Business Over Previous Years
This allows stakeholders to appreciate the trend of data. Thus a low, but steadily
increasing figure for ROCE might be reassuring to investors.
The Results of Ration Analysis for Other Firms in the Same Industry
The results expected from various ratios vary according to the type of firm
under investigation. By comparing like with like a more informed judgement can
be made.
The Results of Rations from Firms in Other Industries
Stakeholders can compare the ratios of a particular business with those from a
wide range of firms. This might allow for example a comparison between two
firms experiencing rapid growth.
A significant weakness of ratio analysis is that it only considers financial aspects of a
business's performance. Other elements of a business should be taken into account when
evaluating performance.
The Market in which the Business is Trading
A business that is operating in a highly competitive market might experience
relatively low profits, depressing ratios such as return on capital employed.
The Position of the Firm within the Market
A market leader might be expected to provide better returns than a small firm
struggling to establish itself. However the small struggling firm may be investing
heavily in R&D and establishing a brand identity. The struggling firm may
generate larger profits in the future.
The Quality of the Workforce and Management Team
These are important factors in assessing a business, but not ones that will be
relieved directly through ratio analysis. Indeed a business that invests heavily in
human resources may appear to be performing relatively poorly through the use
of ratio analysis.
The Economic Environment
In general businesses might be expected to perform better during periods of
prosperity and to produce better results from ration analysis.


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