What Are The Advantages Of Ratio Analysis?

Ratio analysis is the name given to a form of financial statement analysis using the ratio of two financial statements that are related to each other. When compared and 'analysed' together, these statements give a quick yet effective overview of the company's financial operations in several main areas. These analyses or ratios generally can be defined in: Short-term solvency or liquidity ratios, debt management ratios, asset management ratios, profitability ratios and market value ratios, and they are based mainly on accounting information. So, what are the advantages of using this tool to garner information about a company and its future expectations? Well for one thing, ratios help us to instantly check whether a business is sound. When generating comparisons (ratios) to other businesses by way of 'industry standards' and averages, these ratio analyses can be used to discern the limitations of companies, market trends and the general direction that the company can go in as well as how far it can go under the current circumstances. They can also be used to define areas that would need further work, improvement and investigation. Ratio analyses provides an excellent and comprehensive first step towards gaining insight into a firm's performance, strengths and weak points. Things to remember here are that these ratios are not predictive, being based for the most part on 'historical' information. Nor do they reflect the future views of a company. Seasonal influences may distort the findings as would inflation, which should always be taken into consideration. 'Creative accounting' and 'embellishing', differing accounting practices and policies can also misrepresent the findings. Even if you feel that using these rations leaves you with a 'six of one, half a dozen of the other' type of situation, ratio analysis most definitely a very useful tool in the financial world to back up and confirm other findings.

The ratio analysis has the listed advantages:

-makes sure that the company is able the company is able to pay the liabilities

-it shows the operating activities

-it shows the internal return

-it allows the company to monitor performance

In finance, ratio analysis is carried out to judge the liquidity of the organization. It helps the analysts to find if a company is capable enough to pay its liabilities. Moreover it also helps to show the operating efficiency and internal return of an organization. Keep in mind that the ratio is good or bad only if it is compared to the industry in which the organization is operating in.

Some of the important ratios are:

• Current Ratio
• Asset Test Ratio
• Return on Asset
  
• Return on Investment
• Inventory turnover ratio
• Operating Cycle
  

Merits and demerits of ratio analysis

Ratio analysis is an important and age-old technique of financial analysis. The following are some of the advantages of ratio analysis:

Simplifies financial statements: It simplifies the comprehension of financial statements. Ratios tell the whole story of changes in the financial condition of the business
Facilitates inter-firm comparison: It provides data for inter-firm comparison. Ratios highlight the factors associated with with successful and unsuccessful firm. They also reveal strong firms and weak firms, overvalued and undervalued firms.
Helps in planning: It helps in planning and forecasting. Ratios can assist management, in its basic functions of forecasting. Planning, co-ordination, control and communications.
Makes inter-firm comparison possible: Ratios analysis also makes possible comparison of the performance of different divisions of the firm. The ratios are helpful in deciding about their efficiency or otherwise in the past and likely performance in the future.
Help in investment decisions: It helps in investment decisions in the case of investors and lending decisions in the case of bankers etc.

Help in comparison with another company
it also help in analyzing the utilisation of various assets and liability in an organisation