Importance and Uses of Ratio Analysis
The purpose and importance of ratio analysis are to evaluate or analyze the financial performance of the firm in terms of Risk, Profitability, Solvency, and Efficiency. It helps us to compare the trends of two or more company over a period of time.
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.
#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 basically 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.
#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. This is why efficiency ratios are very important, as an improvement will lead to a growth in profitability.
#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 within the operating cycle. For example the salaries due, sundry creditors, tax payable, outstanding expenses etc. Current ratio, quick ratio are used to measure the liquidity of the firms
#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.
#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 helps the firm understand how it is dependent on external capital and whether they are capable of repaying the debt using their own capital.
#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 important decision making by external stakeholders like the investors. They can analyze whether they should invest in a project or not.
#8 – To Compare the Performance of the Firms
The main use of ratio analysis is that the strengths and weakness of each firm can be compared. The ratios can be also compared to the firm’s previous ratio and will help to analyze whether progress has been made by the company.
Conclusion – Importance of Ratio Analysis
As we have discussed the importance and uses of ratio analysis. So its very important to access the performance of the firms by analyzing its liquidity, profitability, asset management, and efficiency ratios. These ratios analysis are widely used for taking important decisions and future forecasting.
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