Thesis: Advantages and Disadvantages of Financial Ratio Analysis

Sample Thesis Paper

Ratio analysis is used globally by diverse sets of people for different purposes. It is used by corporations to assess the debt paying ability of borrowers; investors use ratio analysis to decide between different projects; financial institutions also use ratio analysis to decide whether to lend money; auditors use it for the benefit of their clients and Mergers and Acquisition specialists apply ratio analysis when deciding which business to buy (Gardiner 1995, p. 32).  In an earlier study, Kristy (1994) reported that at the time of publication, there were more than two hundred financial ratios being used by financial institutions, corporations and equity and brokerage professionals (p. 14). However, the useful and applicable ratios are only a select few such as the Current Ratio and the Debt to Equity Ratio.

Ratio Analysis has a number of advantages. Firstly, the financial condition existing within a firm is expressed explicitly and clearly, making it easier to make decisions. Secondly, as more than one item is used to calculate ratios, such as debt and equity, it can be determined if these items are positively correlated, negatively correlated or no correlation exists between the items. Finally, due to the focus on specific areas within the financial statements of the company the problem areas can be identified and rectified accordingly.  Ratio Analysis also has some potential drawbacks. They can make the picture hazy and erroneous by focusing too much on the financial data existing within the books, which is historical data, rather than place more emphasis on current and market information. Secondly, from the point of the investor, ratios of private or semi private firm can be time and cost restrictive in procuring due to unavailability of the data. They are also quite hazardous if not within the precise context that they were analyzed for. Finally, due to accounting policy changes and different year ends used by different companies, a lot of time and tedious labour is required to make these ratios comparable (Texas State Auditor’s Office 1995).

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