Purpose of Ratio Analysis
Ratio analysis is a powerful tool used in financial analysis to evaluate the performance, efficiency, and financial health of a business by comparing various financial metrics. The primary purposes of ratio analysis are:
Performance Evaluation: Ratios help in assessing the profitability, efficiency, and overall performance of a company. By analyzing ratios such as return on capital employed (ROCE) and return on assets (ROA), stakeholders can determine how well the company is utilizing its resources to generate profit.
Financial Health Assessment: Liquidity ratios, such as the current ratio and quick ratio, measure the company's ability to meet its short-term obligations. Solvency ratios, like the debt-to-equity ratio, assess the company's long-term financial stability and ability to meet long-term liabilities.
Operational Efficiency: Efficiency ratios, such as inventory turnover and debtor days provide insights into how effectively the company is managing its assets and liabilities. These ratios help in identifying areas where operational improvements are needed.
Comparative Analysis: Ratios facilitate comparisons between different companies, sectors, or time periods. This helps in benchmarking performance and identifying industry trends. Investors and analysts often use ratio analysis to compare a company's performance with its peers.
Investment Decisions: Investors use ratios to make informed decisions about buying, holding, or selling stocks.
Management Decision-Making: Management uses ratio analysis to make strategic and operational decisions. By analyzing profitability, liquidity, and efficiency ratios, managers can identify strengths, weaknesses, and areas for improvement, enabling better resource allocation and strategic planning.
Financial Planning and Forecasting: Ratio analysis aids in financial planning and forecasting by providing historical data and trends. This helps in setting realistic financial goals, preparing budgets, and forecasting future financial performance.
In summary, ratio analysis serves as a crucial tool for evaluating various aspects of a company's financial performance, facilitating informed decision-making for managers, investors, creditors, and other stakeholders.
Key ratios
| Profitability ratios | Liquidity ratios |
|---|---|
| Gross profit margin | Current ratio |
| Profit margin | Acid test (Quick) ratio |
| Return on Capital Employed (ROCE) |
| Uses of ratio analysis | Limitations of ratio analysis |
|---|---|
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