Importance of Ratio Analysis

Ratio analysis is important for the company to analyze its financial position, liquidity, profitability, risk, solvency, efficiency, operations effectiveness, and proper utilization of funds. It also indicates the trend or comparison of financial results helpful for decision-making for investment by company shareholders.

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

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

• Ratio analysis is vital for assessing a company's financial position, liquidity, profitability, risk, solvency, efficiency, and fund utilization.
• Ratio analysis provides a comparison of financial results and trends, aiding decision-making for company shareholders' investments.
• Ratio analysis facilitates the analysis of financial risks.
• The primary goal of ratio analysis is to compare a company's strengths and weaknesses. This, in turn, contributes to an enhanced decision-making process.
• By comparing current ratios to past ratios, ratio analysis helps evaluate a company's progress.

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 investors 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.

Profitability ratios help to determine how profitable a firm is. Return on Assets and return on equity 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 equity. This ratio tells us how well a company uses its investors' money. Ratios like the gross profit and net profit margin. Margins help to analyze the firm's ability to translate sales to profit.

Certain ratios help us to analyze the degree of efficiency of the firms. Ratios like account receivables turnover, fixed asset turnover, and inventory turnover ratio. 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.

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 cycle. For example, the salaries due, sundry creditors, tax payable, outstanding expenses, etc. The current and quick ratios, measure the liquidity of the firms.

One of the most important reasons to use ratio analysis is that it helps understand the firm's business. Calculating the leverages (financial leverage and operating leverages) allows the firm to understand the business risk, i.e., how its profitability is sensitive to its fixed cost deployment and outstanding debt.

Another importance of ratio analysis is that it helps identify the financial risks. For example, ratios like leverage ratio, interest coverage ratio, DSCR ratio, etc., help the firm understand how it depends on external capital and whether it can repay the debt using its wealth.

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.

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.

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, and efficiency ratios. These ratios analysis are for making important decisions and forecasting the future.

• Coverage Ratio Types
• Solvency Ratios
• Overhead Ratio