Ratio analysis can best be described as the analysis of financial statements in order to obtain the firm’s financial performance of given areas. Ratio analysis is used to evaluate various aspect of a company’s operating and financial performance such as efficiency, liquidity, profitability and solvency.
Difficulties in ratio analysis.
Ratio analysis is more of quantitative rather than qualitative. It mainly deals with numbers and does not account for overheads from activities such as product quality, customer service, and employee morale as well.
Merits of ratio analysis to a:
Elimination of the company’s weaknesses.
Accounting ratios are helpful to managers in unearthing the underperforming areas in the organization and consequently inventing remedial measures to overcome the weaknesses.
Determination of profitability of the company.
Ratios help in analyzing the productivity of the company as shown by profitability ratios. The profitability ratios help managers appraise the performance level of the enterprise at large.
The best way to forecast the future trends of the enterprise is by computation of financial ratios. In business planning, the computation of ratios helps in Swot analysis.
A reliable financial trend evident from financial ratios means that the portfolio is safe to invest in.
To judge the company’s efficiency of its operations and management, financial ratios have to be used by an investor since they help determine how well the company is able to utilize its assets to earn profits.
For comparison purposes, the company’s profitability can be compared with that of the other firms and thereby help a prospective investor to establish the most reliable portfolio to invest in.
The Two Most Important Ratios.
i. Liquidity ratios.
Liquidity ratios are absolutely essential as they provide information on a company’s ability to meet its short-term, immediate obligations. They include: current ratio and quick ratio.
ii. Profitability sustainability ratios.
The importance of these ratios is shown by the fact that they help p