Ratio analysis is a tool for examining and interpreting a company’s financial status. It is a method for judging an organisation’s success by analysing its financial accounts. Ratios are the mathematical representation of the connection between two or more elements in financial statements. Liquidity ratios, profitability ratios, solvency ratios, efficiency ratios, coverage ratios, and market prospect ratios are the six categories of ratios.
Ratio analysis brings many advantages to the users. They identify not only the areas that need the management’s attention but also those in which the organisation excels, allowing the policies in place to be improved.
Before we study the advantages of ratio analysis, let us first know its meaning and objectives.
Meaning of Ratio Analysis
Ratio analysis examines data from financial accounts such as Balance sheet, P&L A/c etc to uncover information about a company’s financial performance, stability, efficiency, and solvency. Ratio analysis can be used to track a company’s performance over time and compare it to other firms in the same sector or field. While ratios provide useful information on the company, they should be used with other tools to provide a complete view of its financial health.
Objectives of Ratio Analysis
Measuring profitability: A company’s ultimate purpose is to make money other than incase of Non-Profit entities. Ratios can be used by it to recognise and modify problem areas.
Operational efficiency evaluation: Certain ratios reflect a company’s level of efficiency in allocating resources and other assets. Capital and financial assets must be distributed and utilised efficiently to avoid excessive expenditures.
Ensure appropriate liquidity: Every company must ensure that part of its resources are liquid in case it needs money right now. Ratio analysis helps a company maintain the required level of short-term solvency.
Financial strength in general: Ratios can be used to determine a company’s long-term solvency. They can warn the company if its assets are weakened or if the company is over-leveraged.
Comparison: To get a clearer view of the organisation’s financial health and debt level, the ratios should be compared to industry standards. If the company fails to meet market criteria, the management can take remedial action. The ratios can also be compared to past years’ ratios to evaluate how far the company has progressed. This is called trend analysis.
Advantages of Ratio Analysis
Helps simplify complex figures and establish relationships
Ratios help in the analysis of complex accounting figures and the identification of their relationships. They aid in the appropriate summarization of financial data and the assessment of managerial efficiency, creditworthiness, and earning capability, among other things.
Helps in comparative analysis
Ratios make it easier to compare the execution of a process or objective with its specified criteria to determine if it is better or worse. The profitability, liquidity, and different elements of a business can be compared in this way:
- for accounting with itself
- in collaboration with other businesses
- following the firm’s or industry’s norms
Indicates efficiency
Inventories turnover and sales turnover ratios are examples of ratios that can be used to determine how successfully a company is utilising its resources and assets to produce sales or deplete inventory. If these ratios are greater, the company is more efficient; however, if they are decreasing over time, it could indicate that stock is building up, the item is becoming obsolete, or the marketing or sales strategy is inadequate, among other things.
Determines solvency
These ratios are useful in determining whether the company’s assets are sufficient to meet the company’s short and long-term viability.
Determines liquidity
Ratio analysis indicates how much money a firm has invested in cash and is useful in determining how much money the company could create on short notice to meet an unforeseen catastrophe. A significant investment in liquid assets, on the other hand, may indicate that the corporation is missing out on higher returns from less liquid securities. As a result, the proper amount of liquidity is desired.
Indicates performance in the market
Ratios can be used to determine if a firm is overvalued or undervalued compared to its peers. It thus aids management in determining how a company’s success relates to its share value and what kind of long-term strategy should be pursued. It also helps investors determine whether they should buy the stock at the current degree of risk.
Reviews profit
Ratios assist in determining how much a firm is worth investing in. If the net profit margin is low, but the gross profit margin is high, it indicates that the company’s expenditures are higher than normal and that the company should analyse them to see if there is room for improvement.
Aids strategic planning
Once management studies the ratios, they can engage in strategic planning, such as capital growth-related initiatives or leasing rather than buying a fixed asset. By combining the data with future market projections, management may design a long-term expansion strategy that can be implemented in stages over time.
Determines budget planning
Operating expenses and other annual expenses and investments are planned using the ratio analysis. For example, if the inventory turnover ratio is very high, an organisation can place large purchases and build up inventory to reduce ordering costs if demand expectations are not changing.
Conclusion
Ratio analysis is important in determining and assessing income, cash flow, revenue growth, risk, capital adequacy, operations effectiveness, and proper fund utilisation. It helps to understand the efficacy of decisions in a company. It also suggests the pattern or comparison of profits, which can be useful for shareholders making investment decisions. It allows us to compare trends between two or more companies throughout time.
