Ratio Analysis is a very important business tool.
Information contained in Profit and Loss Accounts (P&L Account) and Balance Sheets is used by stakeholders to analyze business performance of a firm. With the aid of accounting ratios, business managers can calculate and interpret business accounting information.
And the truth is, we can tell so much about the company’s performance by studying its published Final Accounts.
What is Ratio Analysis?
Ratio Analysis is a quantitative management tool used for calculating, interpreting, analyzing and evaluating the financial performance of a business organization.
A ratio is one number expressed in terms of another number. If a business hires 10 male workers and 20 female workers, then the male-to-female ratio of employees will be 10:20, or 1:2 or 0.5. So, for every one male employee, there are two female workers. And, for every one female worker, there is 0.5 of male workers.
Accounting ratios are calculated using financial data from a firm’s Final Accounts such as Profit and Loss Accounts (P&L Account) and Balance Sheets. The managers’ job is to understand how these ratios are measured, what the results mean and how can different aspects of the business be improved as indicated by the ratio results.
The purpose of using Ratio Analysis
Ratio Analysis is used for interpreting Final Accounts of a business. Final Accounts of companies are analyzed for the benefits of the account users – various stakeholder groups.
- Measure financial performance of a business. The main purpose of using Ratio Analysis is to examine a firm’s overall financial performance. A business must check its financial performance regularly, usually every quarter and every year. This can help to show whether the business is meeting its business aim and business objectives.
- Assess the firm’s position on the market. Specifically, Ratio Analysis also helps business managers to assess a firm’s short-term and long-term profitability position (its ability to control the cost of production and Fixed Costs), liquidity situation, efficiency achievements, long-term debt levels and investment attractiveness.
- Make comparisons between companies. Ratio Analysis allows to compare the actual figures with forecasted numbers. In this way, we can see clearly whether the business is following its budgets or not.
- Influence business strategy. Based on identifying its strengths and weaknesses, business managers will decide which business strategies and business tactics need to be continued, changed or cancelled. Ratio Analysis will also show how much the business needs to improve its future performance, or maybe there is no need to improve after all.
- Help shareholders with making investment decisions. Also, Ratio Analysis aids decision-making for current investors and future investors. The ratio results will guide investors whether they should risk their money by investing in the business.
In summary, it is worth remembering that Ratio Analysis is only valuable, if managers compare apples with apples and oranges with oranges. Meaning, comparing financial ratios with rival businesses of similar size ideally in the same industry makes the most sense. Honestly, there will be very little value for the global market leader comparing its financial ratios against a new start-up business.
