Importance of Ratio Analysis

Ratio Analysis: Meaning

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 makes use of 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 of the same industry with 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 the calculation of 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 again and again. They can simply calculate the ratios, analyze them and take the required action. They will give ample information on the overall efficiency and financial position of the organization.

Ratios such as return on assets, return on equity, etc. help the users to understand the effectiveness with which a company earns a return on its assets. The gross margin ratio tells us about the company’s ability to generate returns on sales. The operating margin gives an overview of the company’s operational efficiency. Other efficiency ratios such as account receivables turnover ratio, inventory turnover ratio, etc. also tell us how efficient the working of the company is.

Importance of Ratio Analysis

Measure of Financial Solvency

Ratio analysis is a useful tool to measure the financial solvency or strength of a company. 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 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 to understand the true financial position of a company.

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 debt of the company in comparison to its equity. As also 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 to 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, achievement level ratios all that gives 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 to identify the risks to the business and how the management is handling it. Calculation of leverage ratios such as the financial leverage and the operational leverage help the users to 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 financial position of the company 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 the gross margin of a company 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 to 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.

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 as well as market value. Stakeholders can go through and use a number of ratios. They need not just rely upon one ratio to take 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 and so on.

Frequently Asked Questions (FAQs)

Why is ratio analysis important?

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

How does ratio analysis help in comparison & decision making?

Ratio analysis helps in making quick comparisons between companies of the same sector or industry which eventually helps stakeholders in evaluating how their company is performing. It also helps the management to understand which area is the company’s weakness and which area wants their immediate attention.

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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