Top 11 Advantages of Ratio Analysis
Ratios are useful tools used for expressing the relationship between data that can be used for internal comparisons and also be used for comparisons across firms. They are used for answering questions that are needed to be answered rather than answering questions directly. Specifically, ratio analysis is advantageous and can be used for the following –
#1 – Ratio Analysis Helps in Analyzing Financial Statements
The first advantage of Ratio analysisRatio 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. is that it provides a broad overview of the company’s health, financial stability, valuation. It helps bankers, investors, as well as management in decision making. This is one of the vital methods of financial statement analysis and can be modified as per user’s needs. Ratios give minute details of each segment of the company
#2 – Ratio Analysis Helps in Judging the Efficiency
The second advantage of Ratio Analysis is that Profitability, solvency ratiosSolvency RatiosSolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease. help assess the company’s overall performance. It helps investors in determining how the company’s operations are going on and how well the management is making decisions. It also helps determine if the company is over or underleveraged. Ratio analysis helps in determining if the assets are well utilized, and the profits are growing at a strong pace. Ratios also help identify if the profits are used wisely. Ratios like dividend yieldDividend YieldDividend yield ratio is the ratio of a company's current dividend to its current share price. It represents the potential return on investment for a given stock. 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. help in understanding how much profit is passed to investors
It basically helps to evaluate a firm’s flexibility .ie. if the firm has the ability to grow and meet its obligations when unexpected events occur
#3 – Ratio Analysis Helps in Determining Weakness
Even though the overall performance may look good, often there can be situations where management’s attention is required. Another advantage of Ratio Analysis is that Ratios like interest coverage, debt service ratio analysis help in getting a detailed understanding. Management can then focus on these areas
#4 – Ratio Analysis Help in Projecting Future Earnings and Cash Flow
Ratios are calculated by using historical figures and are forecasted based on the growth rate of these figures. Ratio analysis can be used in preparing pro forma financial statementsPro Forma Financial StatementsPro forma financial statements refer to reporting the companies' current or projected financial statements based on certain assumptions and hypothetical events that may have occurred or are likely to happen in the future. The company's management can include or exclude line items which they feel may not accurately measure its estimates. that provide estimates of financial statement items for one or more future periods. Ratio analysis and forecasting help management in formulating plans and investors to see how the company is growing.
The advantage of ratio analysis is that these forecasted ratios are then used along with other valuation methods like discounted Cash FlowDiscounted Cash FlowDiscounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company's future performance. Analysis (DCF), Discounted Dividend Model (DDM)Discounted Dividend Model (DDM)The Dividend Discount Model (DDM) is a method of calculating the stock price based on the likely dividends that will be paid and discounting them at the expected yearly rate. In other words, it is used to value stocks based on the future dividends' net present value.. Valuation ratios are used in the analysis of investment in common equity. Ratios like EV/EBITDARatios Like EV/EBITDAEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries., EV/SalesEV/SalesEV to Sales Ratio is the valuation metric which is used to understand company’s total valuation compared to its sales. It is calculated by dividing enterprise value by annual sales of the company i.e. (Current Market Cap + Debt + Minority Interest + preferred shares – cash)/Revenue, Price to BookPrice To BookPrice to Book Value Ratio or P/B Ratio helps to identify stock opportunities in Financial companies, especially banks, and is used with other valuation tools like PE Ratio, PCF, EV/EBITDA. Price to Book Value Ratio = Price Per Share / Book Value Per Share , Price to Earnings are used to come down to a share price. Per-share valuation measures include earning per share (EPSEPSEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.), EBIT per share, and EBITDA per share. The method using ratios is considered as most appropriate since there are less number of assumptions included and is simple
#5 – Comparing Performance to Peers
It is one of the most important advantages of ratio analysis that facilitates comparisons between two companies. It is impossible to compare two companies just by looking at the income statement or Balance Sheet. Investors often wish to understand where the company stands in the sector it operates. It also helps in understanding if the company is overvalued or undervalued among its peers
Apart from comparing itself to peers, it also helps in comparing different divisions in the same company. Most often, management use ratios when they have to decide which division they want to invest in or which division they want to shut down
#6 – Trend Analysis
The other advantage of Ratio analysis is that it helps in understanding the trends over the years. The analyst can easily determine by looking at the numbers whether the company is going up, down, or stable. The comparison can be made easily and helps in determining if the ratio is above or below the benchmark in the industry.
#7 – Ratios Give Meaning to Absolute Figures
As we discussed earlier, it is difficult to understand a company solely based on the numbers provided in the financial statements. Ratios give meaning to numbers and simplify complex accounting statements. For example, if we say that the company has a PE ratio of 1.2x, it will not make much sense if we don’t know what the ratio was like in the last year or what it is now for its peers. Similarly, if we say that the company has revenues of two billion, we cannot interpret if it is good compared to the assets and if the company is selling a maximum of its services or products on credit. Ratios like inventory turnoverRatios Like Inventory TurnoverInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings., account receivable days, accounts payable daysAccounts Payable DaysAccounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period. help in understanding this.
#8 – Analysis of Past Results
Another advantage of Ratio analysis is that it helps in understanding the different relationships and interlinks in the past data and help scrutinize the results.
#9 – Determining Short-Term Liquidity
Current ratiosCurrent RatiosThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities help in determining the short-term liquidity position of the company. These ratios help in understanding whether the firm is able to meet its short-term obligations. Long-term solvency can also be determined using profitability and solvency ratiosSolvency RatiosSolvency Ratios are the ratios which are calculated to judge the financial position of the organization from a long-term solvency point of view. These ratios measure the firm’s ability to satisfy its long-term obligations and are closely tracked by investors to understand and appreciate the ability of the business to meet its long-term liabilities and help them in decision making for long-term investment of their funds in the business..
#10 – Communication
When the management discloses their results, it is always announced in terms of ratios. They focus on ratios like EV/EBITDA, EPS, PE. This is well communicated to the investors. When management talks about a number, it is considered to be well summarized and simplified. Ratios have the power to speak
#11 – Ratio Analysis Helps Analysts do a Better Job
Analysts mainly conduct hardcore number-crunching of the company’s data. Ratios provide an early warning in situations where the company’s performance is going down. Analysts use ratio analysis to evaluate how efficiently the firm is managing its inventory.
For example, the inventory turnover ratio measures how quickly a firm is selling its inventory. Inventory turnover that is too low may be an indication of slow-selling or even obsolete products. Carrying too much inventory is costly, as the firm incurs storage costs, insurance, and inventory taxes. The excessive inventory also ties up cash that might be used more effectively somewhere else. Most of the successful companies have very strong ratios; any fault or weakness in any of the.areas may lead to a strong sell-off. Ratios are also specific to industries. Ratios important for banks may not necessarily be important to manufacture companies; the analyst performs their analysis considering these factors.
As described above, ratios have multiple uses and can be used by everyone starting from management, customers, investors as well as creditors.
This article has been a guide to Ratio Analysis Advantages. Here we discuss the Top 11 advantages and applications of Financial Statement Analysis that can be used by everyone starting from management, customers, investors as well as creditors.