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Ratio Analysis- Importance, Advantages and Limitations

Last Updated : 29 Mar, 2023
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A financial ratio, also known as an accounting ratio, is the size of two numerical values obtained from an organisation’s financial accounts. There are several standard ratios used in accounting to try to analyze the overall financial state of a firm or other entity. Accounting ratios, also known as financial ratios, are used to calculate a company’s performance and profitability based on its financial records. They provide a means of expressing the relationship between one accounting data item along with another and are the origin of ratio analysis. To put it another way, an accounting ratio denotes a quantitative agreement that is used for making decisions and analyses. It serves as the foundation for both intra and inter-firm comparisons.

What are Accounting Ratios?

Accounting ratios are the quantifiable or numerical connection between two accounting data used to assess a company’s performance. Ratios are used to compare many aspects of a company, such as revenue, liquidity, solvency, and efficiency, and can be stated as a percentage, fraction, or decimal. Accounting ratios are those that are determined using financial data documented in a company’s financial statements.

4 Ways of expressing ratio:

1. As a fraction or a ratio

A quotient is a unit of expression of this form, which is formed by dividing one thing by another. As an example: The working capital turnover ratio is \frac{5}{1} . It means that the Net Sales is 5 times the working capital of the business.

2. As a decimal

Ratios are commonly stated as fractions, but they may also be presented as decimals. It can be converted between fractions and decimals when dealing with a mixture of fractions and decimals and comparing ratios presented in either form.

3. As a percentage

It can be expressed in percentage form i.e. by dividing one figure by another and multiplying by hundred. For instance, the Net Profit Ratio is 20%. It represents the connection between net earnings and revenue. This indicates that every ₹100 sale generates a net profit of ₹20 for the company.

4. As a proportion

The quantities of the two figures can be stated in a common thread. For example, the current ratio can be written as 2.5:1. That signifies that the current assets are worth Rs.250 and the current liabilities are worth Rs.100.

Cross-Sectional Analysis

Cross-sectional data analysis is the process of analyzing a data set at a certain moment in time. Cross-sectional data is commonly obtained via surveys and government databases. The datasets include observations of various variables at a specific point in time.

Time Series Analysis

Time series analysis is a method of examining a set of data points gathered over a period of time. Time series analysis involves analysts capturing data points at constant intervals over a predetermined length of time rather than merely occasionally or arbitrarily. This form of analysis, however, is more than just gathering data over time. What distinguishes time series data from other types of data is how the analysis may illustrate how values change over time. In other terms, time is an important variable since it indicates how the data adapt through time as well as the end outcomes. It adds another source of information and establishes a specific sequence of dependencies there between the data.

Importance of Ratio Analysis

Ratio analysis is critical for analyzing a company’s financial condition, liquidity, profitability, risk, efficiency, operational effectiveness, and wise use of cash. It also illustrates the tendency or comparison of economic conditions, which is useful for corporate shareholders’ investment decisions. Different types of accounting ratios provide different information and serve different purposes. 

  1. Liquidity Ratios: These ratios tell about a company’s capacity to pay off short-term debt.
  2. Leverage Ratios: These are responsible to examine the company’s debt level in relation to its capital structure.
  3. Efficiency Ratios: These show a company’s efficiency in the utilization of its resources.
  4. Profitability Ratios: The company’s ability to create profits from revenue is known by these ratios.
  5. Market Value Ratios: Analysis of the company’s stock price is done with the help of these ratios.

Advantages of Ratio Analysis

The benefits of ratio analysis include a quick and easy approach to analyzing a business’s financial results, the ability to compare firms, and the ability to spot patterns and shifts over the years. Here are some of the advantages of Ratio Analysis:

  1. Planning: Through doing trend analysis, it aids in predicting and planning.
  2. Estimation: By analyzing prior trends, it is possible to estimate the firm’s budget.
  3. Informative: It gives users accounting information and important information about the business’s performance.
  4. Solvency: It aids in determining the firm’s liquidity as well as its long-term solvency.
  5. Comparison: It helps in the comparison of different firms on various scales as well as inter-firm analysis.

Limitations of Ratio Analysis

  1. Historical Information: Information used in the analysis is based on past results that the company releases. Therefore, ratio analysis metrics do not necessarily represent future company performance.
  2. Inflationary effects: Financial statements are provided on a regular basis, thus there are time gaps between each publication. If there has been inflation between periods, actual prices are not represented in the financial accounts.
  3. Changes in accounting policies: If the company’s accounting standards and practices have changed, this may have a substantial impact on financial reporting. 
  4. Operational changes: A company’s operational structure can alter dramatically, from its supply chain strategy to the product it sells. When large operational changes occur, comparing financial indicators before and after the change may lead to inaccurate inferences about the company’s accomplishments and various reports.

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