Ratio Analysis: An important accounting tool

TallyDekho brings an introductory guide on a very important accounting tool, Ratio Analysis, used by almost every business enterprise as a measure to check the company’s liquidity, efficiency level, and profitability. In this article, we’ll discuss the importance of ratio analysis in regulating the overall performance of the business.

In a business concern especially large-scale, there are various dimensions the managers take into consideration to check the operational efficiency and profitability of the concern. So, certain ratios are computed to check the overall soundness of the business. Let us first understand what is ratio analysis, its classification and its role as an important accounting tool.

What is Ratio Analysis?

The term ratio analysis consists of two words, ‘ratio’, and ‘analysis’. It refers to analyzing the working efficiency of the business at different levels by computing various ratios. In other words, a method of analyzing a company’s overall performance in the context of efficiency, liquidity, and profitability, is known as ratio analysis.

Basically, ratio analysis is done to check the three main key points considered quite crucial in any business. They are as follows:

• Liquidity

Liquidity refers to the capacity of the company to meet its short-term obligations. Short-term obligations arise when the company uses its current and quick assets. Ratios like current ratio, quick ratio, etc. come under this head.

• Operational Efficiency

Business goes well when the operational level is going well. This is why the business’s primary objective is to maintain operational efficiency. Various leverage ratios are computed to measure the operational efficiency of the concern.

• Profitability

The ultimate goal of any business organization is profit maximization. Therefore, various profitability ratios like gross profit ratio, operating profit ratio, etc are computed to measure the profitability of the business.

Classification of Ratio Analysis

Well, there are numerous kinds of ratios that a business computes to measure its financial viability. However, ratio analysis is classified into four major categories.

Liquidity Ratios

There are a number of short-term obligations that a company has to meet on a regular basis. So, for maintaining liquidity at an appropriate level, it becomes important for a company to compute various types of liquidity ratios. Below are mentioned its types:

• Current Ratio
• Quick Ratio
• Cash Ratio
• Net Working Capital Ratio

Leverage Ratios

In every business organization, it’s very important to keep track of the company’s long-term debt levels and maintain a balance between earnings and long-term debts. These ratios are also known as solvency ratios. Following ratios are computed under this head:

• Debt Ratio
• Debt-Equity Ratio
• Interest Coverage Ratio

Activity Ratios

Popularly known as efficiency ratios, activity ratios are evaluated to measure the efficiency of the company in using its assets and manage liabilities wisely. However, the ultimate goal of computing these ratios is maintaining the efficiency level. Following ratios are computed under this head:

• Inventory Turnover Ratio
• Debtors Turnover Ratio
• Fixed Assets Turnover Ratio
• Total Assets Turnover Ratio
• Capital Employed Turnover Ratio

Profitability Ratios

In any business organization, profit maximization is the ultimate goal of any business. That’s why profitability ratios are considered a crucial part of ratio analysis. It measures the profit-generating capacity of the business from its operations. Following ratios are computed under this head:

• Gross Profit Ratio
• Operating Ratio
• Operating Profit Ratio
• Return on Equity
• Return on Assets
• Return on Sales
• Return on Investment

Significance of Ratio Analysis in business

Every ratio computed is important in measuring various aspects of business operations. Let’s now see the importance of ratio analysis in the business world:

Easy operational planning

With ratio analysis, operational planning becomes easy as the operational managers can easily take corrective measures and plan the future plans according to the inputs computed. Therefore, the planning for operational as well as financial aspects becomes easy.

Accurate performance measurement

No manager can blame any individual department as with the help of ratio analysis, every department is accountable for its performance as per the ratio analysis conducted with the respective inputs.

More transparent communication

The ratio analysis gives a clear outlook of the operational and financial efficiency of the business. Therefore, more transparent communication is possible.

Control on production cost

The ratio analysis helps in identifying the issues and the early detection of the problems helps the management in controlling the overall cost of production and yields a maximum output with minimum inputs.

Reveals financial soundness of the business

With the several ratios computed, it becomes easy for the interested parties to judge the financial soundness of the business.

Reveals repayment capacity of the long-term debts

By computing the debt-equity ratio, it becomes easy for the business to check if their assets are enough to pay the long-term debts of the business. Therefore, ratio analysis helps in analyzing the repayment capacity of the concern.

This way ratio analysis helps in the efficient management of the business operations with profitability and maintaining the efficient working of the employees as well as management. Stay connected for more interesting articles. Feel free to share your feedback.