Significance of Ratio Analysis towards Business Performance

Ratios are guides or shortcuts that are useful in evaluating the financial position of a company and the operations of a company from scientific facts. It helps in comparison of changes in static data from previous years to current year and with the comparison of other companies as well. In accounting and financial management ratios are regarded as the real test of earning capacity, financial soundness and operating efficiency of business concern.

The following points highlight the importance of ratio analysis:

Simplifies Accounting Figures: The most significant objective of ratio analysis is that it simplifies the accounting figures in much easier way by which anyone can be understood it quite easily even for those who do not know the language of accounting.

Measures Liquidity Position: Liquidity position of a firm is said to be satisfactory if it is able to meet its current obligation as and when they mature. A firm is said to be capable of meeting its current obligation only, if it has sufficient liquid funds to pay its short- term obligations within a period of year. Hence, the liquidity ratios are used for the purpose of credit analysis by banks and other short-term lenders.

Measures Long-term Solvency: Ratio analysis is equally important in evaluating the long- term solvency of the firm. It is measured by capital structure or leverage ratios. These ratios are helpful to long-term creditors, security analysts and present and prospective investors, as they reveal the financial soundness or weakness of the firm.

Measures operational Efficiency: Ratios are useful tools in the hands of management to evaluate the firm’s performance over a period of time by comparing the present ratios with the past ratios. Various activity or turnover ratios measure the operational efficiency of the firm. These ratios are used in general by the bankers, investors and other suppliers of credit.

Measures Profitability: The management as well as owners of a firm is primarily concerned with the overall profitability of the firm. Profit and loss account reveals the profit earned or loss incurring during a period, but fails to convey the capacity of the firm to earn in terms of money of sales. Profitability ratios help to analysis earning capacity of the firm. Return on investment, return on capital employed, net profit ratios etc. are the best measures of profitability.

Facilities Inter-firm and Intra-firm comparisons: Ratio analysis is the basic form of comparing the efficiency of various firms in the industry and various divisions of a firm. Absolute figures are not suitable for this purpose, but according ratios are the best tools for inter firm and inter firm comparison.

Trend Analysis: Trend analysis of ratios reveals whether financial position of the firm is improving or deteriorating over years because it enables a firm to take the time dimension into account. With the help of such analysis one can ascertain whether the trend may be increasing.