IMPORTANCE OF RATIO ANALYSIS
GUIDELINES
OR PRECAUTIONS FOR USE OF RATIOS
The calculation of ratios may not be a difficult
task but their use is not easy. Following guidelines or factors may be kept in
mind while interpreting various ratios is
·
Accuracy of
financial statements
·
Objective or
purpose of analysis
·
Selection of
ratios
·
Use of
standards
IMPORTANCE
OF RATIO ANALYSIS
As a tool of
financial statement, ratios are of crucial significance. The importance of
ratio analysis lies in the fact that it presents facts on a comparative basis
& enables the drawing of interference regarding the performance of a firm.
Ratio analysis is relevant in assessing the performance of a firm in respect of
the following aspects:
1)
Liquidity
position
2)
Long-term
solvency
3)
Operating
efficiency
4)
Overall
profitability
5)
Inter firm
comparison
6)
Trend analysis
1)
Liquidity
position
With the help of ratio analysis conclusion can be
drawn regarding the liquidity position of firm. The liquidity position of a
firm would be satisfactory if it is able to meet its current obligation when
they become due. A firm can be said to have the ability to meet its short term
liabilities if it has sufficient liquid funds to pay the interest on its short
maturing debt usually within a year as well as to repay the principal. This
ability is reflected in the liquidity ratio of a firm. The liquidity ratio is
particularly useful in credit analysis by bank & other suppliers of short
term loans.
2)
Long
term solvency
Ratio analysis is equally useful for assessing the
long term financial viability of a firm. This respect of the financial position
of a borrower is of concern to the long term creditors, security analyst &
the present & potential owners of a business. The long term solvency is
measured by the leverage/capital structure & profitability ratio. Ratio
analysis is that focus on earning power & operating efficiency.
Ratio analysis reveals the strength & weakness
of a firm in this respect. The leverage ratios, for instance will indicate
whether a firm has a reasonable proportion of various sources of finance or if
it is heavily loaded with debt in which case its solvency is exposed to serious
strain. Similarly the various profitability ratios whether or not the firm is
able to offer adequate return to its owners consistent with the risk involved.
3)
Operating
efficiency
Yet another dimension of the useful of the ratio analysis
relevant from the viewpoint of management is that it throws light on the degree
of efficiency in management & utilization of its assets. The various
activity ratios measure this kind of operational efficiency. In fact, the
solvency of a firm is in the ultimate analysis dependent upon the sales
revenues generated by the use of its assets- total as well as its components.
4)
Overall
profitability
Unlike the outsides parties, which are interested in
one aspect of the financial position of a firm? The management is constantly
concerned about overall profitability of the enterprise. That is, they are
concerned about the ability of the firm to meets its short term as well as
obligations to its creditors, to ensure a reasonable return to its owners &
secure optimum utilization of the assets of the firm. This is possible if an
integrated view is taken & all the ratios are considered together.
5)
Inter
firm comparison
Ratio analysis not only throws light on the
financial position of firm but also serves s a stepping-stone to remedial
measures. This is made possible due to inter firm comparison & comparison
with the industry averages. A single figure of a particular ratio is
meaningless unless it is related to some standard or norm. One of the popular
techniques is to compare the ratios of a firm with the industry averages. It
should be reasonably expected that the performance of a firm should be in broad
conformity with that of the industry to which it belongs. An inter firm
comparison would demonstrate a firms position vice-versa its competitors. If
the results are at variance either with the industry average or with those of
the competitors, the firm can seek to indentify the probable & in light.
Take remedial measure.
6)
Trend Analysis
Finally, ratio analysis
enables a firm to take the time dimension into account. In other words, whether
the financial position of a firm is improving or deteriorating over the years.
This is made possible by the use of trend analysis. The significance of the
trend analysis of ratio lies in the fact that the analyst can know the
direction of movement. That is, whether the movement is favourable or
unfavourable. For example, the ratio may be low as compared to the norm but the
trend may be upward. On the other hand, though the present level may be
satisfactory but the trend may be a declining one
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