Importance and Uses of Ratio Analysis

It helps us compare the trends of two or more companies over time.

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We shall discuss the importance and uses of ratio analysis in detail below: –

#1 – Analysis of Financial Statements

Interpretation of the financial statements and data is essential for the firm’s internal and external stakeholders. With the help of ratio analysis, we interpret the numbers from the balance sheet and income statements. Every stakeholder has different interests when it comes to financial results. Equity investorsEquity InvestorsAn equity investor is that person or entity who contributes a certain sum to public or private companies for a specific period to obtain financial gains in the form of capital appreciation, dividend payouts, stock value appraisal, etc.read more are more interested in the growth of the dividend payments and the earnings power of the organization in the long run. Creditors would like to ensure that they get their repayments on their dues on time.

#2 –  Helps in Understanding the Profitability of the Company

Profitability ratios Profitability Ratios Profitability ratios help in evaluating the ability of a company to generate income against the expenses. These ratios represent the financial viability of the company in various terms.read more help to determine how profitable a firm is. Return on Assets 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.read more helps to understand the ability of the firm to generate earnings. Return on assets is the total net income divided by total assets. It means how much a company earns a profit for every dollar of its purchases. Return on equity is net income by shareholders equityShareholders EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders’ Equity Statement on the balance sheet details the change in the value of shareholder’s equity from the beginning to the end of an accounting period.read more. This ratio tells us how well a company uses its investors’ money. Ratios like the gross profit and net profit margin Net Profit MarginNet profit margin is the percentage of net income a company derives from its net sales. It indicates the organization’s overall profitability after incurring its interest and tax expenses.read more. Margins help to analyze the firm’s ability to translate sales to profit.

#3 – Analysis of Operational Efficiency of the Firms

Certain ratios help us to analyze the degree of efficiency of the firms. Ratios like account receivables turnoverAccount Receivables TurnoverAccounts Receivable turnover, also known as debtors turnover, estimates how many times a business collects the average accounts receivable per year and is used to evaluate the company’s effectiveness in providing a credit facility to its customers and timely collection. Accounts Receivable Turnover Ratio Formula = (Net Credit Sales) / (Average Accounts Receivable)read more, fixed asset turnover, and inventory turnover ratioInventory Turnover RatioInventory 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.read more. These ratios can be compared with the other peers in the same industry and help analyze which firms are better managed. Second, it measures a company’s capability to generate income by using assets. Third, it looks at various aspects of the firm, like the time it generally takes to collect cash from debtors or the period for the firm to convert the inventory to currency. It is why efficiency ratios are critical, as an improvement will lead to a growth in profitability.

#4 – Liquidity of the Firms

Liquidity determines whether the company can pay its short-term obligations or not. We mean short-term obligations, short-term debts, which one can pay off within 12 months, or the operating cycleOperating CycleThe operating cycle of a company, also known as the cash cycle, is an activity ratio that measures the average time required to convert the company’s inventories into cash.read more. For example, the salaries due, sundry creditors, tax payable, outstanding expenses, etc. The current and quick ratios measure the liquidity of the firms.Measure The Liquidity Of The FirmsLiquidity is the ease of converting assets or securities into cash.read more

#5 – Helps in Identifying the Business Risks of the Firm

One of the most important reasons to use ratio analysis is that it helps understand the firm’s business Business Risk Of The FirmBusiness risk is associated with running a business. The risk can be higher or lower from time to time. But it will be there as long as you run a business or want to operate and expand.read more. Calculating the leverages (financial leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more and operating leveragesOperating LeveragesOperating Leverage is an accounting metric that helps the analyst in analyzing how a company’s operations are related to the company’s revenues. The ratio gives details about how much of a revenue increase will the company have with a specific percentage of sales increase – which puts the predictability of sales into the forefront.read more) allows the firm to understand the business risk, i.e., how its profitability is sensitive to its fixed costFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more deployment and outstanding debt.

#6 – Helps in Identifying the Financial Risks of the Company

Another importance of ratio analysis is that it helps identify the financial risksFinancial RisksFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more. For example, ratios like leverage ratioLeverage RatioDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity.read more, interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company’s current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company’s liquidity position by evaluating how easily it can pay interest on its outstanding debt.read more, DSCR ratioDSCR RatioDebt service coverage (DSCR) is the ratio of net operating income to total debt service that determines whether a company’s net income is sufficient to cover its debt obligations. It is used to calculate the loanable amount to a corporation during commercial real estate lending.read more, etc., help the firm understand how it depends on external capital and whether it can repay the debt using its wealth.

#7 – For Planning and Future Forecasting of the Firm

Analysts and managers can find a trend, use the direction for future forecasting, and be used for critical decision-making by external stakeholders like investors. For example, they can analyze whether they should invest in a project or not.

#8 – To Compare the Performance of the Firms

The main use of ratio analysis is to compare the strengths and weaknesses of each firm. The ratios can also be compared to the firm’s previous ratio and help analyze whether the company has progressed.

Importance of Ratio Analysis Video

Conclusion – Importance of Ratio Analysis

As we have discussed, the importance and uses of ratio analysis. So, it is vital to assess the performance of the firms by analyzing their liquidity, profitability, asset management Asset ManagementAsset management is a method of managing funds and investing in both traditional and specialized products in order to generate returns consistent with the investor’s risk tolerance. read more, and efficiency ratios. These ratios analysis Ratios 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.read more are for making important decisions and forecasting the future.

  • Coverage Ratio TypesSolvency RatiosOverhead Ratio