Advantages and Limitations of Financial Ratios

Discuss about the Advantages and Limitations of Financial Ratios.

Introduction

Every investor is aware of fundamental and technical analysis’s importance for evaluating the performance of the company. Financial ratios are the integral part for the financial statement of the company and it assists in comparing the entities among different accounting periods, among the industries and among the peers. In the same way, if any person wants to analyse the position of personal finance on the basis of his financial statement taking into consideration the net worth, cash flow and liquidity his financial position can be measured based on the financial ratios.

Personal balance sheet and ratio analysis

Ratio	Formula	Result
Current ratio	Current assets / Current liabilities	0.5
Debt equity ratio	Total liabilities/Shareholder's equity	2

It can be identified from the above that the liquidity position of the person is not good as the current assets of the person are half as compared to the current liabilities of the person. Therefore, he is not in a position to cover up his short term obligations with the available short term assets. On the other hand, debt equity ratio of 2 is indicating that the person is highly leveraged as the liabilities are significantly higher as compared to the stakeholder’s equity.

The ratios stated in the article are the savings to income ratio and debt to income ratio whereas the ratios I have considered are the liquidity ratio and the debt to equity ratio. The major differences among the ratios are that the ratios presented in the article have been stressed on the income of the person and the ratios considered by me are stressed on the liquidity position and leverage position of the person. Therefore, the major discrepancy is that the article considered the household income and saving rate while I have considered the business income and leverage position. Another discrepancy is that the article considered the age of the person and his saving rate while I did not consider the age and saving rate and analyzed the ratio at a point of time.

The benchmark ratios presented in the article took 2 important factors that is the age of the people and their saving rate. However, I did not consider these facts and calculated the ratios at a certain point if time and the period beyond that have not been considered. The major factor that brought to my attention that I was not aware of that the age and saving rate plays an important role in computing the personal financial status of the people. For instance, if the person is in the age group of 45 to 50 and has not saved as per requirement, say only 3%, he must increase his income and saving rate significantly to get return in old age. Further, if he made investment in such project that will provide return after long time period, poor performance of the market can become the threat to his return.

Conclusion

From the above discussion I conclude that personal financial ratios are important tool to analyze the financial position of any person. However, it has some limitations that lead to biasness and inappropriate analysis of the personal financial position of any person. The limitations are as follows –

• Inflation – while computing the personal financial position the impact of inflation is not taken into consideration. Assets recorded in the balance sheet that is recorded in the historical value may not have the same value at present date owing to inflation.
• Projected income – the income and saving rate that is projected for the lifetime is projected hypothetically. However, in reality the income and saving rate may not be the same as projected.
• Time period – the ratios are calculated based on the data available at a certain point of time and the data beyond that period or for previous period are not taken into consideration generally. Therefore, computation of savings or retirement earning of any person based on the data at a point of time will be misleading.

Therefore, I suggest that while computing the financial position of any person taking into consideration various ratios, the past performance shall be taken into consideration. Further, the inflation factor shall be taken into consideration while projecting the income and rate of savings.

Bibliography

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Gadoiu, M. (2014). Advantages and limitations of the financial ratios used in the financial diagnosis of the enterprise. Scientific Bulletin-Economic Sciences, 13(2), 87-95.

Griffith.edu.au. (2018). [online] Available at: https://www.griffith.edu.au/__data/assets/pdf_file/0028/205687/Financial-Planning-Research-Journal-V1.pdf [Accessed 7 Jun. 2018].

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