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Advantages of Ratio Analysis

>> December 6, 2011

Ratio analysis is very useful tool of management accounting. With this, we can analyze business's financial position. We also check company's short term and long term solvency with ratio analysis. Following are the main advantages of ratio analysis.

1. Helpful in Decision Making 

All our financial statements are made for providing information. But this information is not helpful for decision making because financial statements provide only raw information. When we calculate different ratios in ratio analysis, at that time, we get useful information. I can explain it with simple example. Suppose, we calculate our interest coverage ratio which is 10times but our competitor company's interest coverage ratio is 15 times. It means capacity of the profit of our competitor company is more than us. By seeing this, we can take decisions for increasing our profitability.

2. Helpful in Financial Forecasting and Planning 

Every year we calculate lots of accounting ratios. When we make trend of all these ratios, we can get useful information for our future forecasting and planning. For example, we can tell five year collection period with following way

2007 = 90 days
2008 = 70 days
2009 = 60 days
2010 = 50 days
2011 = 30 days

From this trend, we know that we are decreasing the days for collection money from our debtors. With this information, we can make two plans. One is effective use of money which we are getting from our debtors more fastly and second we can also check the behavior of our debtors by comparing this with sales trend. Like this, there are lots of ratios which are also useful for better planning.

3. Helpful in Communication 

Ratio analysis are more important from communication point of view. Suppose, we have to appoint new sales agents for our company. At that time, we can communicate them by using our company's sales and profit related ratios. There is no need of hi-tech for understanding the meaning of any specific ratio. For example, our gross profit in 2010 is 26.6% and in 2011, it is 28.55%. By just telling this ratio, we can understand whether our company is growing or falling.

4. Helpful in Co-ordination 

No company has all the strength points. Company's financial results shows some strength points and some weak points. Ratio analysis can create co-ordination between strength points and weak points.

5. Helps in Control 

Ratio analysis can also use for controlling our business. We can easily create the standard of each financial item of our balance sheet and profit and loss account. On this basis, we can also calculate standard ratios. By comparing standard ratios with actual accounting ratios, we can find variance. These variance may be favorable and unfavorable. On this basis, we can control our business from financial point of view.

6. Helpful for Shareholder's decisions 

For example, I am a shareholder. I want to invest in any company's shares. Before buying any company's shares, I will be interested to know company's long term solvency. So, I have to calculate long term solvency ratios. In which, I have to calculate fixed assets to net worth ratio, fixed assets to long term debt ratio. On this basis, I can know the level of fixed assets and its main resource. After checking my money's security, I will be interested to know my return on this investment. ROI, EPS and DPS are most useful ratios which I can calculate for knowing this.

7. Helpful for Creditors' decisions 

Creditors are those persons who provide goods on credit to company or provides short period loan to company. All the creditors are interested to know whether company will repay their debt or not. For this, they calculate current ratio and quick liquid ratio and average payment period. On this basis, they take decisions.

8. Helpful for employees' decisions 

Every employee wants to increase his salary. He also wants to get more and more incentives from company. For this, he takes help from company's profitability ratios. Profitability ratios will be helpful for employees to pressure on the company for increasing their salary.

9. Helpful for Govt. decisions 

Different companies analyze their accounting ratios and publish on the net and print newspapers. Govt. collects all these information. On this basis, Govt. makes policies. If ratios will wrong, Govt. policies will become wrong. For example, Govt. collects income data of all companies in different  industries for calculation the national income. 

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