Practical Use of Ratio Analysis

Understanding the Practical Use of Ratio Analysis

  • Ratio analysis is a crucial tool used by management, stakeholders, and potential investors to evaluate a company’s financial position.
  • It provides quantitative information about a company’s liquidity, profitability, debt repayment ability, operational efficiency, and overall financial health.
  • Ratio analysis is a way of ‘reading between the lines’ of financial statements and understanding the firm’s performance.
  • By comparing these ratios with those of other businesses or the industry standards, an analyst can identify strengths and weaknesses.
  • However, ratio analysis has limitations and should not be used in isolation. They are most valuable when used in combination with other analysis tools.

Use of Ratio Analysis by Management

  • Management can use ratio analysis to identify areas needing improvement and create strategies to boost profitability and efficiency.
  • Ratios like gross profit ratio, operating margin, and others can provide insight into the company’s operational efficiency.
  • Ratio analysis can also help to track a firm’s performance over time, which can aid in decision making for future operations.

Use of Ratio Analysis by Investors

  • Investors can use ratio analysis to assess the financial health of a company and decide whether to invest.
  • Ratios like price/earnings (P/E) ratio and earnings per share (EPS) are commonly used by investors.
  • Investors typically look for companies with excellent ratios as these may suggest strong future performance.

Use of Ratio Analysis by Creditors

  • Creditors are particularly interested in ratios that show a firm’s ability to meet short-term obligations, such as the current ratio and the quick ratio.
  • Creditors may also consider the debt ratio, which shows the proportion of a company’s funding that comes from debt.

Interpreting Results from Ratio Analysis

  • High or low ratios do not always indicate a good or bad financial condition. The interpretation of a ratio depends on the context and industry comparisons.
  • Some ratios should be high, like the current ratio or gross profit margin; others should be low, like the inventory turnover or debt ratio.
  • It’s also important to analyse trends, as a company’s viability may be more about the direction it’s going than its current numbers.

Remember

  • Ratio analysis is both art and science. You need to understand the financials, the industry, and the economy to interpret them properly.
  • Do not rely solely on ratios when making financial decisions. Look at other factors like market conditions, management effectiveness, and industry growth.