Ratio Analysis is a method to understand the liquidity position, efficiency of operations, profitability position, and solvency of a business organization. It is a quantitative technique that uses an organization’s financial statements, such as the income statement and the balance sheet. The ratios and their analysis help us to gauge the financial performance of an organization over different reporting periods. It is particularly important for stakeholders such as the investors, suppliers, and creditors as it serves as a measurement tool of the company’s performance in quantitative terms. With ratios, it becomes easier to compare the performance of the company over the various reporting periods. Moreover, it becomes easier to compare a company’s performance with other companies in the same industry with the help of ratios. Let us now understand the importance of ratio analysis in detail.
Importance of Ratio Analysis
In the financial world, we use various ratios. The objective of analysis guides the type of ratios to be calculated. And, of course, the input to be used for those ratios. We can find all the inputs or figures for calculating these ratios mostly in the financial statements of an organization. Of course, some figures need to be derived before being inputted. The various categories of ratios that we usually calculate and use are liquidity ratios, profitability ratios, solvency ratios, efficiency ratios, coverage ratios, and market prospect ratios. Now let us look at the importance of these specific categories of ratios and their analysis.
Summary of Overall Efficiency
There is a significant volume of accounting data in any organization. Ratios are a way to summarize the financial position of a company. The users of these reports do not require to go through the elaborate financial statements repeatedly. They can calculate the ratios, analyze them and take the required action. They will give ample information on the organization’s overall efficiency and financial position.
Ratios like return on assets and return on equity provide insights into a company’s proficiency in generating returns from its assets. The gross margin ratio offers information about the company’s capacity to derive returns from its sales. Furthermore, the operating margin offers a synopsis of the company’s operational effectiveness. Additional efficiency ratios, such as the accounts receivable turnover ratio and inventory turnover ratio, shed light on the operational efficiency of the company.
Measure of Financial Solvency
Ratio analysis is a useful tool to measure a company’s financial solvency or strength. The stakeholders can evaluate the results and make informed financial decisions. They can compare the ratios of present and past periods to ensure that the company is doing better than in previous quarters or years. Also, the comparison can happen of the ratios with other companies from the same sector or industry. This will help the users understand the company’s true financial position.
Stakeholders like shareholders can judge a company’s financial performance by using the P/E ratio or the dividend payout ratio, or the earnings per share ratio. The debt to equity ratio is a useful metric for the creditors to measure the status of the company’s debt in comparison to its equity, as well as the debt repayment capacity of the company for timely repayment of interest and principal.
Effective Planning and Coordination
Ratio analysis is very important for the internal management of any company too. It gives detailed insight into important metrics and the performance of the company. It helps the management evaluate the results, understand the reasons for the deviations from the budget, and plan effectively for the future. They help in performing the control function as the management gets a clear view of the difference between the planned financials and the actuals. It also helps the management to prepare realistic and achievable budgets and forecasts.
Variation from the budgeted value at various levels and achievement level ratios all give the scenario where the company did good and where it faulted and the reason therefor. This analysis will help the management to take care of these aspects in future planning and budgeting. And thereby, the company achieves budgetary success.
Measure of Business Risk
Ratio analysis helps us identify the business’s risks and how management handles them. Calculation of leverage ratios such as the financial leverage and the operational leverage help the users understand the risk levels of any business that arises out of external debt. By looking at these ratios, a user can immediately get to know how much money the company has borrowed to finance its assets or to what extent a business can extend its operating income.
Ratio analysis also helps us to understand the company’s position to cover its interest payments and debt repayment capacity. And thus, the risk of credit failures can be gauzed. Please note for knowing financial strength and financial or credit risk, we use similar ratios like debt-equity ratio, interest coverage ratio, and debt service coverage ratio, together with some other ratios.
Comparison and Decision Making
Ratio analysis helps the stakeholders of a company to easily understand the company’s financial position instantly. They can make quick comparisons between companies of the same sector or industry. The stakeholders can evaluate how their company is performing. Ratio analysis reveals the true position of a company by providing a basis for comparison and not just mere numbers. For example, the information that a company’s gross margin is $5000 is of no use. It will be useful only when we use it as a ratio of gross margin to sales. This will help the users to immediately understand where the company is standing vis-à-vis its peers. Also, they can compare the ratios of previous years with the current year. This will help them ensure the company is moving in the right direction.
Ratio analysis also helps in the decision-making of the management. By calculating various ratios, the management will easily be able to understand which area is the company’s weakness and which area wants their immediate attention. They can immediately take the required decisions, act on them and rectify the problem, if any. Also, they can use the results for future planning, budgeting, and control functions.
Early Warning System
Certain ratios act as early warning signals for potential financial problems. A sudden deterioration in key ratios can alert management and investors to underlying issues that need to be addressed. Just as an early warning system in other contexts like weather forecasting or security alerts us to potential problems before they escalate, a financial early warning system helps companies, investors, and stakeholders detect financial issues before they become more severe and take appropriate action.
Conclusion: Importance of Ratio Analysis
We can understand the importance of ratio analysis by the fact that it is an all-inclusive package for any business organization. These ratios represent almost every facet of an organization, such as liquidity, solvency, efficiency, profitability, leverage, and market value. Stakeholders can go through and use a number of ratios. They need not just rely upon one ratio to make their decisions.
Ratio analysis brings out the negative aspects of the business, too, along with the positive ones. The management can easily understand what the strengths of the business are and what the weaknesses are. They can detect the unfavorable factors, work on them and eliminate them.
However, stakeholders should not blindly rely upon ratio analysis and be careful while using the results. The management can sometimes manipulate the figures in the financial statements to make these ratios look better. There is no specific format or rule for choosing the components or inputs for calculations. Hence ratios across companies, sectors, or industries may vary. Hence, any decision based on these ratios in isolation should not be taken. Deep digging and multiple ratios should be looked into for a better judgment of the situation.
To learn more, refer to our article LIMITATIONS OF RATIO ANALYSIS.
Frequently Asked Questions (FAQs)
Ratio analysis is important because of the following reasons:
– It provides a summary of overall efficiency
– Helps in measuring financial solvency
– Makes planning & coordination effective
– Identifies business risk
– Helpful in comparison & decision making
Ratio analysis helps make quick comparisons between companies of the same sector or industry, which eventually helps stakeholders evaluate how their company is performing. It also helps the management understand which area is the company’s weakness and which area wants their immediate attention.