Question

Discuss the purpose of financial ratio analysis for internal use?

Answer 1

The purpose of financial ratio analysis for internal use:

Well! In simple words financial ration analysis is used in Financial Decision Making. Now let us discuss that in detail.

Financial Analysis is a popular technique or a tool used by the financial management of a business concern to analyse its performance. It helps to perform a comparative analysis within or outside of the firm.

Ratio Analysis is important in assessing the performance of a firm in respect of following aspects:

i) Comparison: Ratio analysis can be used for inter-firm comparison or comparison with industry averages to which it belongs. An inter-firm comparison would demonstrate the relative position with its competitors. If the difference are high then they can find reasons for these differences and take remedial actions. This will help to predict somewhat future results.

ii) Budgeting: Unlike regular Accounting we need to find the price at the beginning of the period which a product or service must be sold. For that budgeting is required. Using financial ratios we can provide a great deal of assistance in budgeting. It is usually possible to estimate budgeted price using financial ratios.  

iii) Liquidity Position: Financial ratios helps to find the liquidity position of a business concern. It is at most important for a company to maintain a satisfactory amount of liquidity to meet its obligations when they come. With Financial ratios we can find whether a firm is liquid or not, and if not we can take corrective actions. Liquidity positions are used in credit analysis by banks so see whether the firm is eligible for a loan. So it is the duty of the managers to keep the business in a satisfactory liquid position for its reputation.

iv) Long term Solvency: Long term creditors, potential shareholders, security analysts etc use financial ratios to determine the long term solvency of a business concern. They want to know whether the company is safe to invest or lend money, or whether the company has enough strength to keep the business running for a long period of time. They usually uses leverage ratios or profitability ratios to determine this factor. Though this ratios are used by outsiders most of the time, it is used internally to make it strong.

v) Operating Efficiency: Managers use financial ratios to determine the operating efficiency of a firm. Various activity ratios are used to measure operating efficiency.

vi) Overall profitability: Unlike the outside parties which are interested in one aspect of the financial position of a firm, the management is constantly concerned with the overall profitability of the enterprise.