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Advantages and Application of Ratio Analysis

Ratio analysis is a tool used to determine the financial health and operational efficiency of a company. Top management utilizes it to gauge the performance of the company and it helps investors analyze the business from various angles and make an informed choice before investing in it. Ratio analysis offers a number of other advantages.

How Can Company Management Use Ratio Analysis?

Inter-Company Comparison

Ratio analysis can be a great tool for companies to benchmark their performances against the best in the business. If your competitors are doing well, analyzing their financial statements will give you an idea as to which areas are you lacking as against your competitors. This way, you can point out your weak areas or the areas of improvement.

Intra-company Comparison

Ratio analysis can also be used to compare the performance of various departments within the same company. This can be used by the management to find out the departments that are pulling the overall performance of the entire company.

Establishing Future Trends

Although ratios analysis is analyzing past data, it can be helpful in establishing a future trend based on the belief – ‘history repeats itself’.

How Can Investors Use Ratio Analysis?

Investors can use ratio analysis to measure the performance of various companies. Ratio analysis can be used to measure the profitability of various companies, their credit policies, how solvent the company is, how liquid its assets are, is the company management efficient enough etc. Using all this data, the investors can make an informed choice before investing in a company.

Assessment of Liquidity

Liquidity ratios are a class of financial metrics that help determine the ability of a company to meet its immediate short-term debt obligations. Higher is the value of this class of ratios, better is the company in a position to meet its debt obligations. On the other hand, a very high value of this class may suggest that company is not making prudent investment decisions and sitting on a pile of un-invested cash.

Liquidity ratios make use of current assets and current liabilities. Some of the common liquidity ratios are given below.

1.    Current Ratio = Current Assets / Current Liabilities
2.    Acid Test Ratio = (Current Assets – Stocks) / Current Liabilities

Assessment of Long-Term Solvency

Solvency ratios help to determine the ability of a company to meet its long-term obligations. If a company has the low value of solvency ratios, it may cast a doubt in the minds of investors whether the company is capable of meeting its debts and that it may default on its obligations.

Some of the commonly used solvency ratios are given below.
1.    Debt Ratio = Total Debt / Total Assets
2.    Debt-Equity Ratio = Total Liabilities / Total Owner’s Equity
3.    Indebtedness Ratio = Total Debts / Total Liabilities

Assessment of Profitability

One of the most widely used ratios is the profitability ratios. At the end of the day, no matter what company tries to do, its eventual goal is to maximize its profits and wealth. Profitability ratios analyze how profitable is the company in comparison to the investments it has made and the revenue it generates.

Some of the commonly used profitability ratios are as given below.
1.    Net Profit Margin = Net Income / Total Revenue
2.    Return on Equity = Net Income / Average Owner’s Equity
3.    Return on Assets = Net Income / Average Total Assets

Assessment of Operating Efficiency

Efficiency ratios measure how effectively a company utilizes its assets and manages its debts. Efficiency ratios measure the pace of cycle of accounts receivable, accounts payable and the inventory.

Some of the common ratios in this category are given below.
1.    Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
2.    Accounts Receivable Turnover = Revenue / Average Accounts Receivable
3.    Accounts Payable Turnover = Cost of Goods Sold / Average Accounts Payable

Last updated on : April 13th, 2019

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