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.
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 investorsEquity InvestorsAn equity investor is that person or entity who contributes a certain sum to public or private companies for a specific period to obtain financial gains in the form of capital appreciation, dividend payouts, stock value appraisal, etc. 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 Profitability Ratios Profitability ratios help in evaluating the ability of a company to generate income against the expenses. These ratios represent the financial viability of the company in various terms.help to determine how profitable a firm is. Return on Assets and Return on EquityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit. 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 equityShareholders EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period.. This ratio tells us how well a company uses its investors’ money. Ratios like the Gross profit and Net profit marginNet Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization's overall profitability after incurring its interest and tax expenses.. 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 turnoverAccount Receivables TurnoverAccounts Receivable turnover, also known as debtors turnover, estimates how many times a business collects the average accounts receivable per year and is used to evaluate the company's effectiveness in providing a credit facility to its customers and timely collection. Accounts Receivable Turnover Ratio Formula = (Net Credit Sales) / (Average Accounts Receivable), fixed asset turnover, and inventory turnover ratioInventory Turnover RatioInventory Turnover Ratio is a measure to determine the efficiency of a Company concerning its overall inventory management. To calculate the ratio, divide the cost of goods sold by the gross inventory. . 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.
#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 cycleOperating CycleThe operating cycle of a company, also known as the cash cycle, is an activity ratio that measures the average time required to convert the company's inventories into cash.. 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 firmsMeasure The Liquidity Of The FirmsLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.
#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 firmBusiness Risk Of The FirmBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand.. Calculating the leverages (Financial LeverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. and Operating LeveragesOperating LeveragesOperating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues. The ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront.) helps the firm understand the business risk, i.e., how sensitive the profitability of the company is with respect to its fixed costFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity. 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 RisksFinancial RisksFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.. Ratios like Leverage ratioLeverage RatioDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity., interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt., DSCR ratioDSCR RatioDebt service coverage (DSCR) is the ratio of net operating income to total debt service that determines whether a company's net income is sufficient to cover its debt obligations. It is used to calculate the loanable amount to a corporation during commercial real estate lending., etc. help the firm understand how it is dependent on external capital and whether they are capable of repaying the debt using their 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 critical 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 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.
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 managementAsset ManagementAsset management is a method of managing funds and investing in both traditional and specialized products in order to generate returns consistent with the investor's risk tolerance. , and efficiency ratios. These ratios analysisRatios AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements. are widely used for making important decisions and future forecasting.