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.