A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. It may also be defined as the relationship between two accounting figures, expressed mathematically. Ratio Analysis is a useful management tool of a business organization. It’s a simple mathematical expression shown in terms of another number, but it provides important insights in to various financial areas of a business organization.
Notwithstanding that ratio analysis is made on the basis of the accounting data which is historical in nature, but the study of trends and evaluating the past performance of a business can facilitate in effective planning and controlling and forecasting which is of great assistance in decision making process about the future of a business organization. Besides, establishing a relationship between two figures and adding significance, ratios facilitate to make comparison of a firm with its own performance in the past while it enables to compare one business firm with another in the industry. More to the point, a comparison of a firm that has attained expected results can also be made through ratio analysis.
Ratios are calculated on the basis of accounting data that in turn may be classified in a number of ways. They provide what is wanted or needed in a particular situation or by a particular group of people depending upon their interests in business. Liquidity ratios provide the information about the liquidity position of a business, that is, the ability of a business to meet its current obligations which is needed by short term creditors. The long term creditors are interested to know the solvency position of a business which is obtained on the basis of solvency ratios.
As regards the performance of a business organization, the management needs to evaluate all the aspects of a business that are helpful in identifying the activities as well as the performance of a business entity and the same is achieved through activity ratio analysis. Since a business is established to generates revenues and earn profits, it’s appropriate to raise these questions to analyze, such as, whether or not a business is making any money and if it does so, how profitable it is, as compared to the other business firms or competitors. The answers of these important questions are obtained with the help of profitability ratios, as they are used to assess the ability of a business entity to generate earnings. Often, there are times when it is important to determine the company’s financing methods or to know how leveraged the company is. In such situations, the leverage ratios are of great significance, as they are used to calculate the financial leverage of a company to provide the methods of financing and measure the ability to meet the financial obligations.
Having been classified under traditional classification or functional classification or the classification made on the basis of the importance, ratio analysis provide several key benefits to a business organization in order to determine its performance, profitability, liquidity, solvency and its associated risks with the help of coverage ratios. Ratio analysis is one of the important ways of financial analysis and the most common tool of managerial decision making process. If done effectively by a well-experienced person, they can help ward off many problems of a business while they enable to draw conclusions that are of great importance to improve the performance and the profitability of a business entity.
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