Question

Describe ratio analysis including its purpose, application, and interpretation

Answer 1

Ans: Purpose of Ratio Analysis is to evaluate the financial position of the company by company it with peers performance in same industry or its own previous performances with an object of assisting the stakeholders in decision making process.

Some of the Application of Ratio Analysis are as follows:

1. measuring the profitability of the company: it can be with the application Net Profit Margin Ratio, Gross Profit Margin Ratio, Return on Equity etc.

2. Evaluating the operational efficiency of the company by application of turnover ratios.

3. Evaluating the liquidity of the company and its ability to meet its debt requirements.

4. Comparison of company performance with the performance of the industry as a whole to evaluate its market strength and position in industry etc.

Interpretation of ratio analysis can be explained as establishing the relationship between different heads on the financial statements. There are different methods of interpretation of financial ratio out of which most commonly used are historical comparison where ratios are compared using company's own past performances and other method is Inter firm comparison in which company performance is compared and interpreted with respect to the performance of other company in the same industry or industry as an whole.