Why is Ratio Analysis so Important?

Business Analysis

Ratio analysis is the practice of analysing different aspects of financial information found within the company’s financial statements. In most cases, analysts use ratio analysis externally to determine the key financial aspects of the company, such as solvency, liquidity, and profitability. These are some of the key metrics that allow industry leaders to create better business strategies and make the right moves at the right time.

Data analysts need to use past and current financial statements for gathering data that will allow them to get valuable information about the company’s financial performance. With this data, analysts can determine whether the company is improving or worsening financially and compare it to competitors.

Here are different uses of ratio analysis and their importance.

 

Financial statement analysis

Understanding financial statements and their data is crucial for all the stakeholders within a company. Ratio analysis allows us to understand income statements and balance sheet numbers. All stakeholders are interested in different things from financial results. For example, creditors want to ensure that their payments will be made in due time.

 

Better forecasting and planning

One of the crucial benefits of trend analysis for managers and analysts is the ability to make better forecasts. At the same time, it helps promote better critical decision-making for investors and other external stakeholders. Simply put, they can determine if a project is a worthwhile investment or not.

 

Operational efficiency analysis

Some ratios let data professionals learn more about the efficiency of the company. Some of the ratios used for this purpose are:

  • Inventory turnover ratio
  • Fixed asset turnover
  • Account receivables turnover

 

By comparing these ratios with the competition in the industry, it’s easy to see which companies perform better. It measures income generation potential by looking at different aspects of the company, like time to collect debts, the time required to convert inventory into money, etc.

 

Getting a better understanding of the company’s profitability

With profitability ratios, you get to see the actual profitability of a company. On the other hand, return on equity and assets can help determine the company’s ability to generate income. Net profit margin and gross profit ratios give insight into a company’s ability to transform sales into a profit.

 

Understanding company liquidity

Liquidity is an important factor that tells us whether a business can pay all its short-term expenses. By this, we mean things like short-term debts that are paid within the operating cycle or the calendar year, including outstanding expenses, tax payable, salaries, etc.

 

Easier to recognize business risks

Ratio analysis is often used for understanding the risks a company has, and to do that, you need to calculate operating leverage and financial leverage. Simply put, it helps you determine the sensibility of a company’s profitability while looking at outstanding debts and fixed cost deployment.

 

Conclusion

These are all the important use cases for ratio analysis. Companies need to understand their efficiency ratios, asset management, profitability, and liquidity to make accurate forecasts and smarter decisions. At the same time, they can understand their position compared to the competition and determine whether it’s realistic to pursue certain goals.