What is the Meaning of Ratio Analysis? Ratio analysis refers to the analysis and interpretation of the figures appearing in the financial statements (i.e., Profit and Loss Account, Balance Sheet and Fund Flow statement, etc.). So, What we discussing is – Importance, Objectives, Advantages of Ratio Analysis. It is a process of comparison of one figure against another. It enables users like shareholders, investors, creditors, government, and analysts, etc. to get a better understanding of financial statements.
The Concept of Accounting explains Ratio Analysis in the points of Importance, Objectives, Advantages.
Definition of Ratio Analysis: Define the term ratio analysis as “The systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm, as well as its historical performance and current financial conditions, can determine.” Ratio analysis is a very powerful analytical tool useful for measuring the performance of an organization.
Accounting ratios may just use as a symptom like blood pressure, pulse rate, body temperature, etc. The physician analyses this information to know the causes of illness. Similarly, the financial analyst should also analyze the accounting ratios to diagnose the financial health of an enterprise. In this article discussing Ratio Analysis: First Importance of Ratio Analysis, then second Objectives of Ratio Analysis, and finally Advantages of Ratio Analysis.
Importance of Ratio Analysis:
The following 10 best points of Importance of Ratio Analysis below are:
Measure General Efficiency:
Ratios enable the mass of accounting data to summarize and simplify. They act as an index of the efficiency of the enterprise. As such they serve as an instrument of management control.
Measure Financial Solvency:
Ratios are useful tools in the hands of management and other concerned to evaluate the firm’s performance over some time by comparing the present ratio with the past ones. They point out the firm’s liquidity position to meet its short-term obligations and long-term solvency.
Forecasting and Planning:
Ratio analysis is an invaluable aid to management in the discharge of its basic function such as planning, forecasting, control, etc. The ratios that are derived after analyzing and scrutinizing the past result, helps the management to prepare budgets to formulate policies and to prepare the plan of action, etc.
It throws light on the degree of efficiency of the management and utilization of the assets and that is why it is called a surveyor of efficiency. They help management in decision-making.
Ratio analysis provides the inter-firm comparison. They highlight the factors associated with successful and unsuccessful firms. If the comparison shows an unfavorable variance, corrective actions can initiate. Thus, it helps the management to take corrective action.
Intra Firm Comparison:
Intra firm comparisons are facilitating. It is an instrument for the diagnosis of the financial health of an enterprise. It facilitates the management to know whether the firm’s financial position is improving or deteriorating by setting a trend with the help of ratios.
Act as a Good Communication:
Ratios are an effective means of communication and play a vital role in informing the position of and progress made by the business concern to the owners and other interested parties. The communications by the use of simplifying and summarize ratios are more easy and understandable.
Evaluation of Efficiency:
Ratio analysis is an effective instrument that, when properly used, is useful to assess important characteristics of business—liquidity, solvency, profitability, etc. A study of these aspects may enable conclusions to draw relating to the capabilities of the business.
Ratio analysis helps in making effective control of the business- measuring performance, control of cost, etc. Effective control is the keynote of better management. The ratio ensures secrecy.
Detection of Unfavourable Factors:
Analysis of financial statements enables the analyst to find out the soundness or otherwise of the business. If the analysis reveals financial unsoundness, the factors responsible for such unsoundness can separate and corrective action was taken without loss of time.
The Objectives of Ratio Analysis:
The main objectives of ratio analysis are to show a firm’s relative strengths and weaknesses. Other objectives of ratio analysis include comparisons for a useful interpretation of financial statements, finding solutions to unfavorable financial statements and to help take corrective measures when, in comparison to other similar firms, financial conditions and performance of the firm are unfavorable.
Ratio analysis also determines the financial condition and financial performance of a firm. Using ratio analysis allows an analyst to determine the ability of the firm to meet its obligations, the overall operating efficiency, and performance of the firm and the efficiency with which the firm is utilizing its assets in generating sales.
Ratio analysis is a tool used to conduct a quantitative analysis of information in a company’s financial statements. Ratios are calculated by individuals from current year numbers and are these numbers are then used to judge the performance of the company by comparing them to previous years, other companies, the industry or even the economy.
Ratio analysis can help give a quick indication of how a company is doing in certain key areas and the ratios can categorize as short-term solvency ratios, debt management ratios, asset management ratios, profitability ratios, and market value ratios. Ratio analysis should only use as the first step in financial analysis.
As it is a tool that is based on accounting information, it can limit by any distortions that arise in financial statements due to historical cost accounting and inflation. It can also be difficult to draw comparisons using ratio analysis due to differences in the analysis made by other firms.
Using ratio analysis can identify areas that may need to be investigating further. Some of the advantages of ratio analysis include that it helps in credit analysis, it can help in financial performance analysis and that it simplifies a financial statement.
The basic important advantages of Ratio Analysis are also great.
Ratio analysis is an important tool for analyzing the company’s financial performance. The following are the important advantages of the accounting ratios.
Analyzing Financial Statements:
Ratio analysis is an important technique of financial statement analysis. Accounting ratios are useful for understanding the financial position of the company. Different users such as investors, management. bankers and creditors use the ratio to analyze the financial situation of the company for their decision making purpose.
Accounting ratios are important for judging the company’s efficiency in terms of its operations and management. They help judge how well the company has been able to utilize its assets and earn profits.
Accounting ratios can also use in locating the weakness of the company’s operations even though its overall performance may be quite good. Management can then pay attention to the weakness and take remedial measures to overcome them.
Although accounting ratios are using to analyze the company’s past financial performance, they can also use to establish future trends of its financial performance. As a result, they help formulate the company’s plans.
A company needs to know how well it is performing over the years and as compared to the other firms of a similar nature. Besides, it is also important to know how well its different divisions are performing among themselves in different years. Ratio analysis facilitates such comparison.
Main Advantages of Ratio Analysis:
Ratio analysis is widely used as a powerful tool for financial statement analysis. It establishes the numerical or quantitative relationship between two figures of a financial statement to ascertain the strengths and weaknesses of a firm as well as its current financial position and historical performance. It helps various interested parties to evaluate a certain aspect of a firm’s performance.
The following 10 best points are the principal advantages of ratio analysis:
Forecasting and Planning:
The trend in costs, sales, profits, and other facts can know by computing ratios of relevant accounting figures for the last few years. This trend analysis with the help of ratios may be useful for forecasting and planning future business activities.
The budget is an estimate of future activities based on experience. Accounting ratios help to estimate budgeted figures. For example, the sales budget may prepare with the help of an analysis of past sales.
Measurement of Operating Efficiency:
The analysis indicates the degree of efficiency in the management and utilization of its assets. Different activity ratios indicate operational efficiency. The solvency of a firm depends upon the sales revenues generated by utilizing its assets.
Ratios are effective means of communication and play a vital role in informing the position of and progress made by the business concern to the owners or other parties.
Control of Performance and Cost:
Ratios may also use for control of performances of the different divisions or departments of an undertaking as well as control of costs.
A comparison of the performance of two or more firms reveals efficient and inefficient firms, thereby enabling inefficient firms to adopt suitable measures for improving their efficiency. The best way of inter-firm comparison is to compare the relevant ratios of the organization with the average ratios of the industry.
The indication of Liquidity Position:
They help to assess the liquidity position i.e., the short-term debt-paying ability of a firm. Liquidity ratios indicate the ability of the firm to pay and help in credit analysis by banks, creditors and other suppliers of short-term loans.
The indication of Long-term Solvency Position:
They also use to assess the long-term debt-paying capacity of a firm. The long-term solvency position of a borrower is a prime concern to the long-term creditors, security analysts and the present and potential owners of a business. It measures by the leverage/capital structure and profitability ratios which indicate the earning power and operating efficiency. Ratio analysis shows the strength and weaknesses of a firm in this respect.
The indication of Overall Profitability:
The management is always a concern with the overall profitability of the firm. They want to know whether the firm can meet. It is short-term as well as long-term obligations to its creditors, to ensure a reasonable return to its owners. And, secures optimum utilization of the assets of the firm. This is possible if all the ratios are considered together.
The signal of Corporate Sickness:
A company is sick when it fails to generate a profit continuously and suffers a severe liquidity crisis. Proper ratio analysis can give the signal of corporate sickness in advance. So, timely measures can take to prevent the occurrence of such sickness.
Aid to Decision-making:
They help to make decisions like whether to supply goods on credit to a firm. Whether bank loans will make available etc.
Simplification of Financial Statements:
They make it easy to grasp the relationship between various items and helps in understanding the financial statements.