Meaning of Ratio Analysis:
“Ratio analysis is a study of relationship among various financial factors in a business.”
—Myers
Ratio analysis is a process of determining and interpreting relationship between the items of financial statements to provide a meaningful understanding of the performance and financial position of a enterprise. Thus, it is a technique of analysing the financial statements by computing ratio.
Importance of Ratio Analysis:
Ratio analysis serves the purpose of various users who or interested in the financial statements. It simplifies, summaries and systematizes the figures in the financial statements.
The objectives of ratio analysis can be better understood from the following importance of ratio analysis:
1. Useful in Analysis of Financial Statements : Ratio analysis is an extremely useful device for analyzing the financial statements. It help the bankers, creditors, investors, shareholders etc. in acquiring enough knowledge about the profitability and financial health of the business. In the light of the knowledge so acquired by them, they can take necessary decisions about their relationships with the concern.
2. Simplification of Accounting Data: Accounting ratio simplifies and summaries a long array of accounting data and makes them understandable. It discloses the relationship between two such figures which have a cause and effect relationship with each other.
3. Helpful in Comparative Study: With the help of ratio analysis comparison of profitability and financial soundness can be made between one firm and another in the same industry. Similarly, comparison of current year figures can also be made with those of previous years with the help of ratio analysis.
4. Helpful in Locating the Weak Spots of the Business: Current year’s ratios are compared with those of the previous years and if some weak spots are thus located remedial measures are taken to correct them.
5. Helpful in Forecasting: Accounting ratios are very helpful in forecasting and preparing the plans for the future. For example, if sales of a firm during this year are Rs 10 lakhs and average amount of stock kept during the year was Rs 2 lakhs i.e., 20% of sales and if the firm wishes to increase sales next year to Rs 15 lakhs it must be ready to keep a stock of Rs 3,00,000 i.e., 20% of 15 lakhs. Similar other estimates for future can be worked out by establishing a relationship between capital and sales debtors and sales expenses and sales etc.
6. Estimate About the Trend of the Business: If accounting ratios are prepared for a number of years they will reveal the trend of costs, sales, profits and other important facts.
7. Fixation of Ideal Standards : Ratio helps us in establishing ideal standards of the different items of the business. By comparing the actual ratios calculated at the end of the year with the ideal ratios, the efficiency of the business can be easily measured.
8. Effective Control : Ratio analysis discloses the liquidity, solvency and profitability of the business enterprise. Such information enables management to assess the changes that have taken place over a period of time in the financial activities of the business. It helps them in discharging their managerial functions e.g., planning, organizing, directing, communicating and controlling more effectively.
