Financial Analysis

Ratio Analysis Objectives, Advantages and Limitations

Meaning and Definition of Ratio Analysis

Ratio analysis is a process of comparing two numbers with respect to each other. It is a mathematical or quantitative indicator about two numerical values which indicate the proper compare of respective ratio with each other.

Similarly, in finance, ratios are a correlation between two numbers of two different accounts; through we get to carry out an evaluative analysis of information in the financial statements of a company to get a more clear understanding of them.

These ratios are calculated from the current year’s financial figures and compared them to previous years. Analyzing those to find out reasons behind the current financial position of the business.

So, certainly, its recent financial performance, and pull out prospects about its future viewpoint. Above all,  proponents of financial analysts use ratio analysis to analyze the performance.

By using these ratio analysis tools, managers and investors use to analyze and compare to tell whether a company is doing business well and it is worth investing in.

The most common ways people analyze a company’s performance are vertical analysis, horizontal analysis, and ratio analysis. Horizontal and vertical analyzes compare a company’s performance over time.

The ratio analysis provides the scrutiny to decide a manager or investor about how healthy the business is as a whole and can better understand different aspects of the company’s operations.

Let us take an example:

The income for the year from operations is 1,00,000/- for a given year. The Purchases and other direct expenses cost is around 75,000/-.

So the Gross Profit f the year is 25,000/-. Now we can say that the Gross Profit is 25% of the Operations Revenue. We can calculate this as:

Gross Profit Ratio = Gross Profit/Sales×100

Gross Profit Ratio = 25,000/1,00,000 ×100

i.e. G.P. Ratio = 25%

Read| Profitability Ratio

Objectives and Benefits of Ratio Analysis

Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us take some objectives that ratio analysis.

      • Determines Profitability

Ratio analysis assists managers to work out the production of the company by figuring the profitability ratios. Also, the management can evaluate their revenues to check their productivity.

Thus, probability ratios are helpful to the company in appraising its performance based on current earning. Profit is the ultimate aim of every company.

If we say, XYZ is a company which last year earned profit is 1 lac. how will you determine the earned profit is a good or bad figure? In this context, to measure profitability with the help of a tool like a ratio analysis.

Gross Profit Ratio, Net Profit Ratio, Expense Ratio, etc are measured the profitability of a company. Consequently, one can determine earned profit is good or bad or improve upon them.

      • Determines Operational Efficiency

With the help of ratio analysis, we can check and update the certain degree of efficiency of a company in the management of its assets and other resources.

It is essential that assets and financial resources can be allocated and used efficiently to avoid unnecessary expenses of the company. The efficiency can be measured and pointed out the mismanagement of assets with these ratios like -Turnover Ratios and Efficiency Ratios.

      • Helping in evaluating solvency

By computing the solvency ratio, a company is able to keep an eye on the relation magnitude between the assets and the liabilities.

The company is able to know its financial position; if in any case, the liabilities are more than the assets or any other solvency issue of the company. This is more helpful in case if the company wishes to set up a plan for loan repayment.

      • Determines Suitable Liquidity

Every company has to ensure that some of its assets are liquid to overcome short time obligations and liquidate immediately into cash. So the liquidity of a firm is measured by ratios such as the Current Ratio and Quick Ratio.

      • Better financial analysis

Ratio analysis is also helpful to shareholders, debenture holders, and creditors. more to the point, bankers are also able to know the profitability of the company to find out whether they are able to pay the dividend and interests under a specific period.

      • Performance Financial Strength

Every company has to determine the firm’s long-term solvency through which they can determine if there is a strain on the assets of a company or if the company is over-leveraged.

The management of the company will need to quickly rectify the situation and review their performance to avoid liquidation in the future. Examples of such ratios are Debt-Equity Ratio, Leverage ratios, etc.

      • Forecasting

At present, many companies use ratio analysis to reveal the trends in production. This provides them an opportunity for estimation of future trends and thus the foundation for budget planning so as to determine the course of action for the growth and development of the business.

The management can take corrective action if the standards of the market are not met by the company. The ratios can also be compared to the previous years’ ratios to see the progress of the company. This is known as trend analysis.

Read| Accounting Ratio and their types

Advantages and Disadvantage of Ratio Analysis

Financial ratio analysis is a useful tool for users of financial statements. It has the following advantages:

Advantages of Ratio Analysis

    1. It simplifies the financial statements.
    2. This helps in comparing companies of different sizes with each other.
    3. Helps to validate or disprove the financing, investment and operating decisions of the firm
    4. Assists in trend analysis which involves comparing a single company over a period.
    5. Highlights important information in simple form quickly. A user can judge a company by just looking at a few numbers instead of reading the whole financial statements.
    6. Facilitates to identify problem areas and bring the attention of the management to such areas

Disadvantage of Ratio Analysis

Despite usefulness, financial ratio analysis has some disadvantages. Some key demerits of financial ratio analysis are:

    1. Different companies operate in different sectors, each having different environmental conditions such as regulation, market structure, etc. Such factors are so significant that a comparison of two companies from different industries might be misleading.
    2. Estimates and assumptions affect financial accounting information. Accounting standards allow different accounting policies, which impairs comparability, and hence ratio analysis is less useful in such situations.
    3. Ratio analysis explains relationships between past information while users are more concerned about current and future information.
    4. It ignores the price level changes due to inflation. Many ratios are calculated using historical costs, and they overlook the changes in price level between the periods. This does not reflect the correct financial situation.

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