Importance of Ratio Analysis

Importance and Uses of Ratio Analysis

Ratio Analysis is important for the company in order to analyze its financial position, liquidity, profitability, risk, solvency, efficiency, and operations effectiveness and proper utilization of funds which also indicates the trend or comparison of financial results that can be helpful for decision making for investment by shareholders of the company.

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

Importance of Ratio Analysis

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

#1 – Analysis of Financial Statements

Interpretation of the financial statements and data is essential for all internal and external stakeholders of the firm. 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 the result from the financial like the 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 many does a company earn a profit for every dollar of its assets. 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 of the same industry and will help to analyze which firms are better managed as compared to the others. It measures a company’s capability to generate income by using the assets. It looks at various aspects of the firm like the time it generally takes to collect cash from debtors or the time period for the firm to convert the inventory to cash. 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. By short-term obligations, we mean the short term debts, which can be paid off within 12 months or the operating cycle. For example, the salaries due, sundry creditors, tax payable, outstanding expenses, etc. The current ratio, quick ratio are used to 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 in understanding the business risk of the firm. Calculating the leverages (Financial Leverage and Operating Leverages) helps the firm understand the business risk, i.e., how sensitive the profitability of the company is with respect to its fixed cost deployment as well as debt outstanding.

Operating Leverage - Colgate

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

Another importance of ratio analysis is that it helps in identifying the Financial Risks. Ratios like Leverage ratio, interest coverage ratio, DSCR ratio, etc. help the firm understand how it is dependent on external capital and whether they are capable of repaying the debt using their capital.

Leverage Ratio - Colgate

#7 – For Planning and Future Forecasting of the Firm

Analysts and managers can find a trend and use the trend for future forecasting and can also be used for critical decision making by external stakeholders like the investors. 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 that the strengths and weaknesses of each firm can be compared. The ratios can also be compared to the firm’s previous ratio and will help to analyze whether progress has been made by the company.

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 its liquidity, profitability, asset management, and efficiency ratios. These ratios analysis are widely used for making important decisions and future forecasting.

You may learn more about Ratio Analysis from the following articles –

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  1. Avatarfabby bonde says

    Thank you, they were very helpful