Ratio, in general, shows a proportional relationship between two different numbers or quantities. It may be a relationship between two amounts that is represented by a pair of numbers showing how much greater one amount is than the other, that is, the ratio of something to something. When undertaken by a business management in the process of Financial Analysis in order to identify the financial strengths and weaknesses of a business entity.
Effective planning and Financial Management are the keys to running a financially successful business. Ratio analysis is a useful management tool that assists in effective planning and running a financially successful business. Ratios, on the one hand, help greatly in summarizing the large amount of financial data by making the interpretation of financial statements easier; they enable to make qualitative judgment about a business firm’s financial performance on the other. It’s through the ratio analysis that the liquidity, solvency, profitability and the activity of a business entity may be identified in an accurate manner.
Ratio Analysis is a powerful tool of Financial Analysis. Having simplified the understanding of Financial Statements, ratios reveal the inter relationship between various financial figures which in turn enables analyst to gain insights in making forward-looking and projections accordingly. Though the ratio analysis is made on the basis of the accounting data which is historical in nature, but the study of trends can also facilitate in effective planning and controlling and forecasting.
Besides, establishing a relationship between two figures and adding significance, ratios facilitate to make comparisons between a firm’s past and present performance, while they also aid greatly in comparing one business firm with another.
As pointed out above, 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. The information about the liquidity position, that is, the ability of a business to meet its current obligations, is needed by short term creditors, whereas the long term creditors are interested to know the solvency position of a business. As regards the performance of a business, 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.
It’s true that the ratios are just supplementary to the absolute figures taken from the Income statement and the balance sheet, but they reveal absolutely true story of a business entity that is not to be directly expressed in the absence of Ratio Analysis. Thus, the ratio analysis plays a significant role in the process of Financial Analysis through which a business is enabled to find good prospects and perform better while it’s also facilitated for ranking management’s ability.
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