Ratio analysis is important in the determination of a firm’s profitability. It helps to determine a firm’s productivity through computation of profitability ratios and to calculate their revenue productivity to determine a firm’s performance based on current earnings. It is to calculate the solvency of a firm to monitor the correlation existing between assets and liabilities. Companies can determine their financial position when liabilities are more than assets (Murphy, 1999). It provides vital information to bankers to determine the profitability of a business and the possibility of paying interests and dividends. In addition, this tool can be used to determine production trends. A company can forecast and estimate its future trends. It is a good foundation for budgeting that enables a company to employ a better course of action to achieve success and growth.
Ratio analysis has various demerits such as the difficulty to compare ratios of different firms since some companies may prefer LIFO basis instead of FIFO basis. There may be cases when differences occur in determining depreciation in fixed assets or the certainty in the provision of doubtful debts. False results may occur in case of incorrect data from accounting records. Wrong financial position can occur when stock valuation is based on a higher price causing inflation in profits it can cause effects on price level changes in commodities making comparison difficult causing negative implications on production cost, value of assets, and sales. Since ratio analysis is a quantitative tool, using it ignores quantitative factors which are very crucial in business planning. Effects of window-dressing may occur particularly when a company decides to cover up bad financial position. Ratio analysis is a very costly technique hence small investments cannot use it. It leads to misleading result when there is lack of absolute data. It is inappropriate due to lack of a standardized universal accepted terminology because there are no universally accepted standard ratios to be used for comparison purposes.
Odd lot theory
In technical financial analysis, odd lot theory states that investors should make decisions on investments dissimilar to what small investors do. Odd lotters have low risk tolerance and little information on business decisions (Jan et al, 2008). Therefore, an investor can predict the market by dealing in an opposite commodity contrary to what odd lotters are selling to make profit. If sales of odd lotters exceed purchases, an informed investor should by. But if the purchases exceed the sales, an investor should sell. The theory is based on the premise that odd lotters make misinformed decisions.
Difference between fundamental and technical analysis