Importance of Ratio Analysis

Definition of Ratio Analysis

Ratio analysis includes evaluating data from current and historical financial statements to understand company financial performance throughout the industry. It helps to set a trend line of a company’s performance over a period, which tells whether the company is showing growth or not.

What is Ratio Analysis?

Financial analysis of the company is done by analyzing many factors; ratio analysis is a very important part of financial analysis to understand its financial statements, position in the market, liquidity, operating efficiency, etc. it is based on a fundamental analysis of the company. It helps the investor understand the company’s performance through its financial statements.

Categories of Ratio Analysis

Here we discuss the categories of ratio analysis:

• Liquidity Ratios: Company’s ability to pay out the short-term debt.
• Leverage Ratios: Evaluate the company debt level in the capital structure.
• Efficiency Ratios: Company’s efficiency in the utilization of its resources.
• Profitability Ratios: Ability of the company to generate income from revenue.
• Market Value Ratios: Evaluation of the company’s share price.

Understanding Ratio Analysis

Fundamental and quantitative analysis performed with the help of ratio analysis, which helps to understand the financial health of the company and its performance over a period with data gathered from the historical financial statements of the company.

Successful companies mostly have solid ratios indicating good financial health and growth over a period, and management ability to handle problems in various aspects of the business. It is important to perform ratio analysis from all aspects of the company to make decisions since a single ratio might be deceitful but after understanding all ratio investors get a complete picture of company performance over a period and future expectations from the company.

Importance of Ratio Analysis

Importance of ratio analysis are given below:

1. Financial Statement Analysis

Understanding financial statements are important for stakeholders of the company. Ratio analysis helps in understanding the comparison of these numbers; furthermore, it helps in estimating numbers from income statements and balance sheets for the future. For e.g. Equity shareholder looks into the P/E ratio, the Dividend payout ratio, etc. while creditors observe Debt to Equity ratio, Gross margin ratio, Debt to asset ratio, etc.

2. Efficiency of Company

Ratio analysis is important in understanding the company’s ability to generate profit. Return on Asset, Returns on Equity tell us how much profit the company is able to generate over assets of the firm and equity investments in the firm, while gross margin and operating margin ratios tell us the company’s ability to generate profit from sales and operating efficiency.

3. Planning and Forecasting

From a Management and investor point of view, ratio analysis helps to understand and estimate the company’s future financials and operations. Ratios formed from past financial statement analysis helps in estimating future financials, budgeting, and planning for the future operations of the company.

4. Identifying Risk and Taking Corrective Actions

The company operates under various business, market, operations related risks. Ratio analysis helps in understanding these risks and helps management to prepare and take necessary actions. Leverage ratios help in performing sensitivity analysis of various factors affecting the company’s profitability like sales, cost, debt. Financial leverage ratios like Interest Coverage ratio and Debt Coverage ratio tell how much the company is dependent on external capital sources and the company’s ability to repay debt.

5. Peers Comparison

Investor, as well as the company’s management, makes a comparison with Competitors Company to understand efficiency, profitability and market share. Ratio analysis is helpful for companies to perform SWOT (Strengths, Weakness, Opportunities, and Threats) analysis in the market. It also tells whether the company is able to perform growth or not over a period from past financials and whether the company’s financial position is improving or not.

6. A Better Source of Communication

Ratio analysis is important while presenting the financials of the company to its stakeholders. Ratios make it easy to understand than complex and huge numbers. Sometimes numbers can be deceitful which leads to investors losing confidence, but ratio analysis helps the investor to understand the situation of the company after comparison and helps them to keep investing in the business.

7. Financial Solvency

The company’s ability to pay short-term debt is determined by liquidity. Current Ratio, Acid-test ratio tells us whether a company is able to pay its short-term obligation within a year. The company continuously runs analysis on past financial statements to understand and prepare for payment of short-term obligations.

8. Decision Making

Ratios provide important information on the operational efficiency of the company, and the utilization of resources by the company. It helps management to forecast and planning for future, new goals, concentrate on the different markets, etc.

9. Trend Line

Ratio analysis gives us the trend line, which indicates whether a company is able to perform over a period or not. Companies gather data from past reporting periods trend line formed can be used to understand and judge future performance and any possible issue which cannot be found from just one-year ratio analysis.

10. Important Tool

Financial analysis of the company cannot be done without ratio analysis. Ratio analysis is an important tool that is required to perform all actions whether the comparison with peer companies, measuring the efficiency of the company in various aspects of creating a financial model of the company to forecast future performance.

11. All in One Package

Ratio analysis includes ratios, which measure various aspects of business like liquidity, efficiency, solvency, leverage, profitability and market value. It gives reliable information to investors and management from all perspectives to make their own decisions. An investor should not depend on just one ratio to make investment decisions but should perform a thorough analysis of various ratios and understand its meaning related to the company’s future performance.

Conclusion

Ratio analysis is an important part of understanding business operations and the ability to perform in the market. For an investor, it is important to perform ratio analysis from all angles of business instead of just one or two angles, because while some ratios might provide positive insights while others will show negative impact on company performance, to understand full picture 360 degree analysis is very important which can be done only after analyzing all ratios.

There is a certain limitation on ratio analysis like a company doing year-end changes in financial statements to improve ratios, this window dressing can be deceitful for investors, price level changes are ignored in ratio analysis and there are no specific standards for every ratio.

Although ratio analysis only shows but did not help in improving the performance of the business, it is still treated as an important tool that provides 360-degree analysis to understand company finances and make necessary decisions for the future.

Recommended Articles

This is a guide to the Importance of Ratio Analysis. Here we discuss the introduction and categories of ratio analysis along with the importance. You may also look at the following articles to learn more –

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