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 analysis 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 users 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 ratios help asses the company’s overall performance. It helps investors in determining how the company’s operations are going on and how well the management is taking decisions. It also helps determine if the company is over or underleveraged. Ratio analysis helps in determining if the assets well utilized and the profits are growing at a strong pace. Ratios also help identify if the profits are used wisely. Ratios like dividend yield and return on equity 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 detail 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 statements 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 Flow Analysis (DCF), Discounted Dividend Model (DDM). Valuation ratios are used in the analysis for investment in common equity. Ratios like EV/EBITDA, EV/Sales, Price to Book, Price to Earnings are used to come down to a share price. Per-share valuation measures include earning per share (EPS), 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
This is one of the most important advantage of ratio analysis is that it facilitates comparisons between two companeis. 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 a 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 turnover, account receivable days, accounts payable days 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 ratios 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 the profitability and solvency ratios
#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 summarised 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, 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 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.
- Example of Common Size Income Statement Format
- Examples of Common Size Balance Sheet Format
- Example of Vertical Analysis Formula
- What is the Use of Trend Analysis?
- Pro Forma Income Statement – Types
- Types of Pro Forma Cash Flow Statement
- Pro-Forma Earnings Definition
- Limitations of Ratio Analysis
- Credit Analysis Ratios
- Vertical Analysis Common Size
- Horizontal Analysis of Financial Statements
- Industry Analysis Guide