Importance of Ratio Analysis

Updated on May 13, 2024
Article byPritha Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

Importance and Uses of Ratio Analysis

Ratio analysis is important for the company to analyze its financial position, liquidity, profitability, risk, solvency, efficiency, operations effectiveness, and proper utilization of funds. It also indicates the trend or comparison of financial results helpful for decision-making for investment by company shareholders.

It helps us compare the trends of two or more companies over time.

Ratio Analysis Importance

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We shall discuss the importance and uses of ratio analysis in detail below: –

Key Takeaways

  • Ratio analysis is vital for assessing a company’s financial position, liquidity, profitability, risk, solvency, efficiency, and fund utilization.
  • Ratio analysis provides a comparison of financial results and trends, aiding decision-making for company shareholders’ investments.
  • Ratio analysis facilitates the analysis of financial risks.
  • The primary goal of ratio analysis is to compare a company’s strengths and weaknesses. This, in turn, contributes to an enhanced decision-making process.
  • By comparing current ratios to past ratios, ratio analysis helps evaluate a company’s progress.

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#1 – Analysis of Financial Statements

Interpretation of the financial statements and data is essential for the firm’s internal and external stakeholders. With the help of ratio analysis, we interpret the numbers from the balance sheet and income statements. Every stakeholder has different interests when it comes to financial results. Equity investors are more interested in the growth of the dividend payments and the earnings power of the organization in the long run. Creditors would like to ensure that they get their repayments on their dues on time.

Ratio Analysis Framework 2

#2 –  Helps in Understanding the Profitability of the Company

Profitability ratios help to determine how profitable a firm is. Return on Assets and return on equity helps to understand the ability of the firm to generate earnings. Return on assets is the total net income divided by total assets. It means how much a company earns a profit for every dollar of its purchases. Return on equity is net income by shareholders equity. This ratio tells us how well a company uses its investors’ money. Ratios like the gross profit and net profit margin. Margins help to analyze the firm’s ability to translate sales to profit.

Gross Profit margin - Ratio Analysis colgate

#3 – Analysis of Operational Efficiency of the Firms

Certain ratios help us to analyze the degree of efficiency of the firms. Ratios like account receivables turnover, fixed asset turnover, and inventory turnover ratio. These ratios can be compared with the other peers in the same industry and help analyze which firms are better managed. Second, it measures a company’s capability to generate income by using assets. Third, it looks at various aspects of the firm, like the time it generally takes to collect cash from debtors or the period for the firm to convert the inventory to currency. It is why efficiency ratios are critical, as an improvement will lead to a growth in profitability.

Total Asset Turnover - Ratio Analysis - Colgate 1

#4 – Liquidity of the Firms

Liquidity determines whether the company can pay its short-term obligations or not. We mean short-term obligations, short-term debts, which one can pay off within 12 months, or the operating cycle. For example, the salaries due, sundry creditors, tax payable, outstanding expenses, etc. The current and quick ratios, measure the liquidity of the firms.

Solvency Ratios 2

#5 – Helps in Identifying the Business Risks of the Firm

One of the most important reasons to use ratio analysis is that it helps understand the firm’s business. Calculating the leverages (financial leverage and operating leverages) allows the firm to understand the business risk, i.e., how its profitability is sensitive to its fixed cost deployment and outstanding debt.

Operating Leverage - Colgate

#6 – Helps in Identifying the Financial Risks of the Company

Another importance of ratio analysis is that it helps identify the financial risks. For example, ratios like leverage ratiointerest coverage ratioDSCR ratio, etc., help the firm understand how it depends on external capital and whether it can repay the debt using its wealth.

Leverage Ratio - Colgate

#7 – For Planning and Future Forecasting of the Firm

Analysts and managers can find a trend, use the direction for future forecasting, and be used for critical decision-making by external stakeholders like investors. For example, they can analyze whether they should invest in a project or not.

Financial Modeling Interview - Cost Forecast

#8 – To Compare the Performance of the Firms

The main use of ratio analysis is to compare the strengths and weaknesses of each firm. The ratios can also be compared to the firm’s previous ratio and help analyze whether the company has progressed.

Box IPO  Comparable Analysis Comp1

Importance of Ratio Analysis Video

Conclusion – Importance of Ratio Analysis

As we have discussed, the importance and uses of ratio analysis. So, it is vital to assess the performance of the firms by analyzing their liquidity, profitability, asset management, and efficiency ratios. These ratios analysis are for making important decisions and forecasting the future.

Frequently Asked Questions (FAQs)

1. What are the objectives of ratio analysis?

Ratio analysis aims to evaluate a company’s financial performance, assess its operational efficiency, measure profitability, determine liquidity and solvency, analyze risk levels, and gauge the effective utilization of funds. It helps identify strengths and weaknesses, make informed decisions, monitor financial health, and compare performance against industry benchmarks.

2. What are the limitations of ratio analysis?

Ratio analysis has certain limitations. It relies on historical financial data, which may not reflect future performance accurately. Ratios can be distorted by accounting practices or manipulation. It may not consider external factors or qualitative aspects of a company’s operations. Comparisons with industry benchmarks may not account for differences in company size or specific industry dynamics.

3. What is the difference between ratio analysis and trend analysis?

Ratio analysis involves calculating and interpreting financial ratios to assess a company’s performance and financial health. It focuses on comparing relationships between different financial data points. On the other hand, trend analysis examines the patterns and changes in financial data over time, such as revenue, expenses, or other key metrics.

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  1. fabby bonde says

    Thank you, they were very helpful