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Ratio Analysis - Definition & Advantages of Ratio Analysis | What is Ratio Analysis?

Ratio analysis is a process used to assess a company's financial performance by comparing various financial variables. These variables can include liquidity, profitability, solvency, and efficiency ratios. The data used in ratio analysis is usually taken from the company's financial statements, which provide detailed information on the company's financial performance over a period of time.

The importance of ratio analysis is that it provides valuable insights into a company's financial health. It can be used to identify strengths and weaknesses, monitor performance, and make informed decisions. Ratio analysis can also be used to compare the financial performance of different companies within the same industry, allowing investors to make informed decisions about where to invest their money.

What Kinds of Ratio Analysis Are There?

There are several types of ratios which can be widely classified into these four types : -

  1. Liquidity ratios - These ratios measure a company's ability to meet its short-term obligations. Examples include the current ratio and the quick ratio.

  2. Profitability ratios - These ratios measure a company's ability to generate profit. Examples include the gross profit margin and the return on assets.

  3. Solvency ratios - These ratios measure a company's ability to meet its long-term obligations. Examples include the debt-to-equity ratio and the interest coverage ratio.

  4. Efficiency ratios - These ratios measure a company's ability to manage its resources effectively. Examples include the inventory turnover ratio and the asset turnover ratio.

Ratio analysis typically involves four steps

  1. Gather pertinent accounting information from financial statements

  2. Building ratios using pertinent accounting figures.

  3. It compares the ratios created with the benchmark ratios, which might be the firm's historical ratios, the average industry ratios, or the ratios of rival companies.

  4. Ratio interpretation to reach reliable conclusions.

Ratio Analysis's Goals

  • Evaluate the financial performance of a company over a period of time.

  • Identify trends and patterns in the company's financial performance.

  • Compare the financial performance of different companies within the same industry.

  • Identify strengths and weaknesses in a company's financial performance.

Ratio analysis's benefits include the following:

  1. Forecasting and planning: By calculating ratios of pertinent accounting numbers from the most recent several years, it is possible to determine the trend in costs, sales, profits, and other facts. Ratio-based trend analysis may be helpful for forecasting and organizing upcoming company activity.

  2. Budgeting: It is the practice of projecting future actions based on information from the past. Budgeted amounts can be launched using accounting ratios.

  3. Efficiency: Ratio analysis reveals the efficiency level in managing and utilizing its assets. This is how operating efficiency is measured.

  4. Communication: In informing the owners or other parties about the situation and progress of the business concern, ratios are an excellent communication tool.

  5. Regulate Performance and Cost: Ratios can also be used to control the costs of an endeavor and the performance of its many departments or divisions.

  6. Inter-firm comparison: Comparing the performance of two or more businesses exposes which ones are efficient and which ones are not, allowing the latter to take the necessary steps to become more efficient.

  7. Indication of Liquidity Position: Ratio analysis aids in determining a company's liquidity position or capacity to pay the short-term debt.

  8. Indicates Long-term solvency position: Ratio analysis also evaluates a company's ability to pay off its debt in the long run.

  9. Indicates Overall Profitability: Ratios helps the management about the profitability of the business.

  10. Helps  in decision-making: When deciding whether to offer a firm credit for the supply of goods or whether to make bank loans available, among other things.

  11. Simplify Financial Statements: Ratio analysis makes it simple to understand the connections between different things and aids in the comprehension of financial statements.

  12. Proactive Approach: An organization is sick when it experiences a severe liquidity crisis and consistently fails to earn a profit. Proper ratio analysis can detect corporate sickness early on, allowing for the prompt implementation of preventative measures.