What if you could uncover the true financial standing of an organization with a handful of figures? This is exactly what a ratio analysis could help you accomplish. Through this detailed blog on financial ratio analysis, you will learn everything about it – who should do it, when to do it, and what challenges it carries etc. By the end of this blog, you will be confident to write a ratio analysis assignment on any given topic.
What Is Meant by Ratio Analysis?
Ratio analysis is a process of inspecting the financial health of an organisation by closely reviewing and analysing its key financial statements. Cash flow statements, balance sheets or income statements. As these statements are the true indicators of a company’s day-to-day financial performance, analysing them carefully can provide real insights into whether the company is doing good or needs any corrections in its current approach.
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Why Is Conducting Ratio Analysis Important for Businesses?
Performing ratio analysis is important for every organization to know about its financial health. It can benefit multiple stakeholders in the business – finance department, company management, compliance department etc. Here are the top reasons why carrying out it is essential:
To understand cash-flow trends:
Through ratio analysis, businesses can have a more realistic picture of their cash-flow trends such as how money comes in and goes out. To predict whether it can manage its expenses smoothly over time, this data is essential.
To know about overall profitability:
Accounting ratio analysis is a powerful tool to understand if the business is making enough profit compared to its operational costs. Every business needs to have the capacity to grow and sustain itself by making a profit beyond the operational costs.
To verify if operations are efficient:
By financial ratios concerning operational expenses, businesses can know how well their resources like employees, equipment, and money are being used and if the investment in these areas is making the ROI.
To understand liquidity standing:
Another great advantage of periodical ratio analysis is that it helps to determine if the business can pay its short-term debts. Through the analysis, the stakeholders can have their status of cash or assets availability.
To figure out long-term solvency:
Besides liquidity standing, the analysis of ratio is also useful in getting to know about the business’s long-term solvency or the ability to pay off long-term debts. Creditors decide to pass long-term loans based on this report.
What Are the Different Categories of Ratio Analysis?
Business or accounting students who prepare for ratio analysis assignments writing often struggle with the various categories it presents. For instance, why a certain type of it is asked in a specific scenario? So, here are all the details you need to know about the four major types or categories of ratio analysis.
Profitability Ratio:
As you may have guessed from the term itself, the profitability ratio is the figure derived from the comparison between a company’s expenses and revenue. A healthy profitability ratio means the company is making more money after all the expenses.
Liquidity Ratio:
In financial ratio analysis, liquidity ratio refers to the comparison of short-term liabilities with current cash or assets. The goal of liquidity ratio assessment is to identify its ability to repay short-term debts.
Activity Ratio:
Activity ratio compares a company’s ongoing operations or activities against the revenue generation. What it tries to uncover is how profitably the company is making use of its resources and generating revenue from it.
Solvency Ratio:
The purpose of solvency ratio analysis is to understand a business’s long-term capability to pay off depths. As such, it brings under its inspection the debt levels, equity and annual revenue. While the liquidity ratio is often required by short-term creditors, banks or government entities may require businesses to submit their solvency ratio.
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What Are the Uses of Ratio Analysis?
With ratio analysis, businesses can have multiple use cases. From understanding their performance to demonstrating their creditworthiness to lenders to attracting investors. Below are some of the common ratio analysis examples in terms of their uses.
Creditworthiness Assessment:
Financial ratios can be useful in getting to know the company’s ability to pay off its short-term as well as long-term debts. By knowing this, lenders can decide whether there is any credit risk and inform their decisions.
Investment Feasibility:
External companies or people interested in investing in a company may find the ratio analysis useful as it gives a clear picture of the financial health of the company and potential investment feasibility.
Evaluation of patterns:
By analysing ratios over multiple reporting periods, stakeholders can identify patterns in their company’s performance. These reports can be very useful for them in forecasting future financial decisions or strategic planning
How to Do Ratio Analysis – 5 Easy Steps to Follow
Your ratio analysis assignment may require you to carry out one choosing any of the categories. Check the below steps which explain how to do ratio analysis with examples.
1. Identify Core Ratios to Analyse
First of all, you need to know what ratio you need to calculate to achieve the goal you are trying to. For instance, if your goal is to check the company’s short-term financial health, you need to do a liquidity ratio analysis.
2. Collect Relevant Financial Data
Once you have decided on the ratio category to go ahead with, collect relevant data from your respective financial statements. Balance sheet or income statement whatever documents offer the insights.
3. Derive ratio by applying the right formulas
Apply appropriate formulas to calculate the chosen ratios. In the case of calculating liquidity ratio, the formula is to divide your liquid assets by short-term liabilities.
4. Review the results using benchmarks
Once you have got the ratio, check how it compares with the industry benchmarks to get a real status of your performance in the specific scenario. If your liquidity ratio is 2.0 and the industry average of 1.5, it shows you are in a good position.
5. Analyse the findings
After deriving insights from the ratios and their standing against the industry norms, it is recommended to make sense of the implications and inform your decisions. A high debt-to-equity ratio might mean you are excessively relying on borrowed funds.
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What are the Benefits and Drawbacks of Ratio Analysis?
Ratio analysis is a very useful procedure to assess financial performance through using metrics like liquidity, profitability, and solvency. However, it is worth noting that this tool has both advantages and limitations.
Benefits of Ratio Analysis
- Facilitates making budget estimations by providing insights into past trends.
- Offers meaningful insights into business performance for key stakeholders.
- Liquidity ratio and solvency ratio help prove creditworthiness to convince lenders.
- Useful in making strong financial predictions through pattern evaluations.
- Very helpful in understanding the operational efficiency of a company
- Creates a space for comparing the business’s standing with competitors or industry norms
Drawbacks of Ratio Analysis
- Diverse accounting methods used by companies may make data comparability nonpractical.
- The interpretation of financial accounting data can sometimes be influenced by personal perspectives and assumptions.
- Oftentimes, the financial statements for ratio analysis may seem complicated to process.
- Cross-industry comparisons, which is a standard norm in ratio analysis, often offer unclear results.
- The focus of ratio analysis on historical data, rather than current or future information, may limit its practical usefulness.
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Conclusion
Ratio analysis is a very useful approach to figure out the financial health of any business. By evaluating the key ratios, you will know where the business stands in terms of profitability, liquidity, and overall performance. We hope this blog was useful to you and informed you on how to apply ratio analysis effectively in specific contexts. If you have any questions or would like to share your thoughts, please feel free to leave feedback in the comments.
