Question

Why are financial ratios useful in financial analysis?

Answer 1

The basis for financial analysis, planning and decision making is financial statements which mainly consist of Balance Sheet and Profit and Loss Account where the profit & loss account shows the operating activities of the concern and provides aid in determining the profitability of an entity and the balance sheet shows the financial position of entity at the specific point of time.

However in current scenario due to dynamics of business, it is necessary to analyse the data depicted in the financial statement for ascertaining the financial strengths as well as the weaknesses of an enterprise.

One of the tools used for such data analysis is ratio analysis.

Ratio Analysis is based on the fact that a single accounting figure by itself may not communicate any meaningful information but when expressed relative to some other figure, it may definitely provide some meaningful information which helps in more accurate decision making. It involves not just comparing different numbers from the balance sheet, income statement, and cash flow statement. It involves comparing the number against previous years, other companies, the industry, or even the economy in general for the purpose of financial analysis.

Usefulness of Financial Ratio in financial analysis: The importance of ratio analysis lies in the fact that it presents facts on a comparative basis and enables drawing of meaningful inferences regarding the financial position and performance of a firm.

It helps in assessing performance of an entity in respect of following aspects:

1. Liquidity Position: Ratio analysis helps in drawing meaningful conclusion regarding liquidity of an firm. The liquidity position of a firm would be considered as satisfactory if it is able to meet its obligations when they become due. This ability is reflected in the liquidity ratios of a firm. The liquidity ratios are particularly useful in credit analysis by banks and other suppliers of short-term loans.

2. Long term Solvency: Not only liquidity, ratio analysis also helps to determine the solvency of an entity. This aspect of the financial position of a borrower is of concern to the long term creditors, security analysts and the present and potential owners of a business. The long term solvency is measured by the leverage/capital structure and profitability ratios which focus on earning power and operating efficiency of an enterprise.

The leverage ratios, for instance, will indicate whether a firm has a reasonable proportion of various sources of finance or whether it is in high debt in which case its solvency is exposed to serious strain. On the other hand, profitability ratios enables us to determine whether or not the firm is able to offer adequate return to its fund providers consistent with the risk involved.

3. Operating Efficiency: Ratio analysis also provide aid in determining the operational efficiency of an enterprise. Activity ratios like Total Asset Turnover Ratio, Fixed Asset Turnover Ratio, Stock Turnover ratio, Debtor Turnover Ratio etc can be used to measure operational efficiency.

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

The reason is that they are concerned about the ability of the firm to meet its short-term as well as long- term obligations to its creditors, to ensure a reasonable return to its owners and secure optimum utilisation of the assets i.e. increasing Throughput contribution of the firm. This is possible if an integrated view is taken and all the ratios are considered together.

5. Inter firm comparison: Ratio analysis not only helps in measuring the current performance against past performance i.e. Intra firm comparison but it also helps to do \inter-firm comparison/comparison with industry averages and competitors.