Ratio Analysis Advantages

Ratio analysis advantages refer to the list of benefits that calculation and assessing ratio analyses of different types offer firms and businesses. When the ratio analysis is conducted, it helps companies assess their market position and keep a check on their performance. As a result, these analyses help businesses make better and more effective business decisions.

Studying the ratio analysis advantages enables entities to understand how calculating different ratios and assessing them can allow them to analyze their figures and find out the truths about their performance. If these ratios indicate that the performance is not appropriate, they can implement more fruitful strategies for growth.

• Ratio analysis advantages include their usefulness in expressing relationships between data and allowing for comparisons within a company. 
• Ratio analysis is beneficial for analysts to assess a company's inventory management and identify early warning signs of declining performance.
• Considering industry-specific ratios is crucial, as certain ratios may be more relevant for specific industries. Analysts take into account these industry-specific factors while conducting their analysis, recognizing that what matters for banks may differ from what matters for manufacturing companies.

Ratio analysis advantages are many, given that firms do not depend on only one of them. There are multiple ratios that can be calculated to be further analyzed to check the business performance. The types of ratios that firms can calculate can be liquidity ratio, solvency ratio, debt-to-equity ratio, operating efficiency ratio, etc.

There are profitability ratios that help businesses learn about their pace toward growth and progress. It tells businesses about the profits they can expect or compare their profits from the previous financial year or quarter, thereby letting them assess the difference in their position then and now.

Ratios also exist in the form of risk ratios that allow businesses to know the percentage of risk associated with an investment or deal. As a result, they get prepared beforehand to deal with the expected losses and also work on ensuring the risks get avoided in some way.

Ratios are useful tools used for expressing the relationship between data that can be used for internal comparisons and also be used for comparisons across firms. They are used to answer questions that need to be answered rather than answering questions directly.

When these ratios are assessed, they either indicate the progress of the business or identify the lags. If the ratio analysis results exhibit growth, the companies know they can continue with the same strategies as they are turning fruitful for them. On the other hand, if the results indicate an opposite scenario, the firms examine their present strategies and try to improve and implement better ones to ensure growth.

To get the best ratio analysis advantages, it is recommended that the firms do not rely on one ratio calculation and analysis and conduct multiple analyses for a more reliable conclusion. This is because one ratio analysis results may mislead firms, but if multiple analyses exhibit similar results, the conclusion is considered to be more accurate.

There are many advantages of conducting ratio analysis of which a few are the most sought-after ones. Let us check out the benefits that calculating different ratio analyses can offer firms and businesses.

The top 11 advantages of ratio analysis have been listed below:

#1 - Analyzes Financial Statements

The first advantage of Ratio analysis is that it provides a broad overview of the company’s health, financial stability, and valuation.

It helps bankers, investors, as well as management in decision making. It is one of the vital methods of financial statement analysis and can be modified as per users' needs. Ratios give minute details of each segment of the company.

#2 - Ratio Analysis Helps in Judging the Efficiency

The second advantage of Ratio Analysis is that Profitability, solvency ratios help assess the company's overall performance. It helps investors determine how the company's operations are going on and how well the management is making decisions. It also helps determine if the company is over or underleveraged. Ratio analysis helps determine if the assets are well utilized, and the profits are growing quickly.

Ratios also help identify if the profits are used wisely. Ratios like dividend yield and return on equity help in understanding how much profit is passed to investors

It helps to evaluate a firm's flexibility. if the firm can grow and meet its obligations when unexpected events occur

#3 –Determines Weakness

Even though the overall performance may look good, often, there can be situations where management's attention is required.

Another advantage of Ratio Analysis is that Ratios like interest coverage debt service ratio analysis help get a detailed understanding. Management can then focus on these areas.

#4 –Projects Future Earnings and Cash Flow

Ratios are calculated using historical figures and are forecasted based on the growth rate of these figures. Ratio analysis can prepare pro forma financial statements that provide estimates of financial statement items for one or more future periods—ratio analysis and forecasting help management formulate plans and investors to see how the company is growing.

The advantage of ratio analysis is that these forecasted ratios are then used along with other valuation methods like discounted Cash Flow Analysis (DCF), Discounted Dividend Model (DDM). Valuation ratios are used in the analysis of investment in common equity. Ratios like EV/EBITDA, EV/Sales, Price to Book, Price to Earnings are used to come down to a share price. Per-share valuation measures include earning per share (EPS), EBIT per share, and EBITDA. The method using ratios is considered as most appropriate since there are less number of assumptions included and is simple.

#5 - Compares Performance to Peers

One of the most important advantages of ratio analysis is that it facilitates comparisons between two companies. It is impossible to compare two companies by looking at the income statement or Balance Sheet. Investors often wish to understand where the company stands in the sector it operates.  It also helps understand if the company is overvalued or undervalued among its peers.

Apart from comparing itself to peers, it also helps compare different divisions in the same company. Most often, management uses ratios when they have to decide which division they want to invest in or which division they want to shut down

#6 - Helps in Trend Analysis

The other advantage of Ratio analysis is that it helps understand the trends over the years.

The analyst can easily determine whether the company is going up, down, or stable by looking at the numbers. The comparison can be made easily and helps determine if the ratio is above or below the benchmark in the industry.

#7 - Gives Meaning to Absolute Figures

Ratios give meaning to numbers and simplify complex accounting statements. As we discussed earlier, it isn't easy to understand a company solely based on the numbers provided in the financial statements. For example, if we say that the company has a PE ratio of 1.2x, it will not make much sense if we don't know what it was like in the last year or what it is now for its peers. Similarly, if we say that the company has revenues of two billion, we cannot interpret if it is good compared to the assets and if it is selling a maximum of its services or products on credit. Ratios like inventory turnover, account receivable days, accounts payable days help understanding this.

#8 - Helps Analyze Past Results

Another advantage of Ratio analysis is that it helps in understanding the different relationships and interlinks in past data and helps scrutinize the results.

#9 - Determines Short-Term Liquidity

Current ratios help in determining the short-term liquidity position of the company.

These ratios help in understanding whether the firm can meet its short-term obligations. Long-term solvency can also be determined using profitability and solvency ratios.

#10 - Enables Communication

When the management discloses their results, it is always announced in ratios. They focus on ratios like EV/EBITDA, EPS, and PE. It is well communicated to the investors. When management talks about a number, it is considered to be well summarized and simplified. Ratios have the power to speak

#11 - Helps Analysts do a Better Job

Analysts mainly conduct hardcore number-crunching of the company's data. Ratios provide an early warning in situations where the company's performance is going down. Analysts use ratio analysis to evaluate how efficiently the firm manages its inventory.

For example, the inventory turnover ratio measures how quickly a firm is selling its inventory. Inventory turnover that is too low may indicate slow-selling or even obsolete products. Carrying too much inventory is costly, as the firm incurs storage costs, insurance, and inventory taxes. The excessive inventory also ties up cash that might be used more effectively somewhere else. Most successful companies have very strong ratios, any fault or weakness. Areas may lead to a strong sell-off. Ratios are also specific to industries. Ratios important for banks may not necessarily be important to manufacture companies; the analyst analyzes these factors.

As described above, ratios have multiple uses and can be used by everyone starting from management, customers, investors as well as creditors.

This article has been a guide to what are Ratio Analysis Advantages. We explain the topic with the top 11 advantages for management, customers, investors, & creditors. You may also have a look at the following finance articles as well.

• Trend Analysis Examples
• Limitations of Ratio Analysis
• Credit Analysis Ratios
• Industry Analysis