Monday, June 13, 2011

SIGNIFICANCE OR IMPORTANCE OF RATIO ANALYSIS

Q. What is the significance or importance of Ratio Analysis:

 

Mainly the persons interested in the analysis of the financial statements can be grouped under three heads (i) Owners or investors, (ii) Creditors and (iii) Financial executives. The importance of analysis varies materially with the purpose for which it is calculated. The primary information which seeks to be obtained from these statements differs considerable reflecting the purpose that the statement is to serve.

 

The significance of these ratios varies for these three groups as their purpose differs widely. These investors are mainly concerned with the earning capacity of the company whereas the creditors including bankers and financial institutions are interesting in knowing the ability of enterprise to meet its financial obligations timely. The financial executives are concerned with evolving analytical tools that will measure and compare costs, efficiency, liquidity and profitability with a view to making intelligent decisions.

 

The Significance or importance of Financial ratio analysis can be judged from the following facts.

 

1.  A useful tool in the hands of analyst:

Ratios are exceptionally useful tools with which one can infer the financial performance of the enterprise over a period of time, with the help of ratio analysis conclusions can be drawn regarding several aspects such as financial health profitability and operational efficiency of the undertaking. The financial health of the concern can be known with the help of different ratios. Ratios point out firm’s liquidity position to meet its short-term obligations and long term solvency. They indicate strength and weaknesses of the firm.

2.  Inter-Firm comparison:

Ratio analysis provides inter-firm comparison or comparison with industry averages by comparing the firms ratios with those of other competitive and progressive firms. An inter firm comparison exhibits the firms relative position vis-a-vis its competitors. If comparison shows a variance, the possible reasons of variations may be identified and if results are negative the corrective actions may be initiated immediately bring them in line. It is also helpful in forewarning the corporate sickness and helps the management to take corrective action.

3.  Trend Analysis:

Ratio analysis enables a firm to take the time dimension into account. In other words, it facilitates the management to know whether the firms financial position is improving or deteriorating or is constant over the years by setting a trend with the help of ratios. The analyst with the help of ratio analysis can know the direction of movement whether favourable or unfavourable. An analysis of the trend of strategic ratios may help the management in the task of planning, forecasting and controlling.

Thus ratio analysis plays a very important role in the interpretation of the financial statements correctly and to make the figures comparable and more meaningful.

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