Ratio Analysis is one of the indispensable tools used to interpret the financial statements of a company. It yields such results which help in easy understanding of the company’s overall performance.
If the process of computing ratios is carried out properly, it can highlight the areas where the performance of the company is lacking as compared to that of the entire industry. Such information could prove to be of great importance. This would help the management to design and implement better policies in the future, thereby enhancing the growth of the company.
Ratio analysis offers a variety of advantages to its user. They not only pinpoint the areas that require the immediate attention of the management but also highlight the areas in which the company is excelling so that the available policies can be polished.
Advantages of Ratio Analysis –
There are various advantages of ratio analysis. Some of which are listed below:
- Simplification of complex figures – This is one of the major advantages of ratio analysis as it helps in converting complex financial figures and accounting data into simpler numbers. This ensures that all stakeholders can easily interpret the financial position of a company.
- A better understanding of decisions – Accounting ratios helps in deciding whether the management has invested the funds in the appropriate operating, investing, and financing activities.
- Comparative analysis – Not only do accounting ratios help in comparing a company’s performance with that of its past year’s performances, but it is also an important measure to make inter-company comparisons.
- Areas of concern – Ratio analysis brings various problem-related areas and other deviations in the overall working of the company to the knowledge of the management. With immediate attention to these areas, the overall efficiency is improved.
- Forecasting and planning –The management studies the trend in the financials over the past years which aids the management in preparing future budgets and forecasts.
- Communication –Ratios serve as an effective means of communication. They convey the financial position of the company to its owners and other stakeholders in the best possible way.
- Evaluation of efficiency – They provide a detailed overview of the performance of the business with the help of liquidity, solvency, and profitability ratios. Combined with other ratios, the efficiency of the entire business can easily be evaluated.
- SWOT Analysis – Ratio Analysis provides information regarding the changes occurring in the These changes facilitates the SWOT analysis, i.e, Strength-Weakness-Opportunity- Threat analysis.
When ratio analysis is employed correctly, it throws light on various problems faced by the company. It could be said that accounting ratios essentially work as a whistleblower. They bring the problem areas to the attention of the management, which is one of the major advantages they provide.
Chapter 5 – Accounting Ratios