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Ratio Analysis - Definition & Advantages of Ratio Analysis | What is Ratio Analysis?

Ratio analysis evaluates a company's financial performance by comparing financial variables such as liquidity, profitability, solvency, and efficiency ratios. This data is usually derived from the company's financial statements. The importance of ratio analysis lies in its ability to provide insights into a company's financial health, identify strengths and weaknesses, monitor performance, and aid in decision making. 

Types of Ratio Analysis

Ratio analysis can be broadly classified into four types: 

  1. Liquidity ratios (e.g., current ratio, quick ratio)
  2. Profitability ratios (e.g., gross profit margin, return on assets)
  3. Solvency ratios (e.g., debt-to-equity ratio, interest coverage ratio)
  4. Efficiency ratios (e.g., inventory turnover ratio, asset turnover ratio)

Steps in Ratio Analysis

  1. Collect accounting information from financial statements
  2. Create ratios using relevant accounting figures
  3. Compare created ratios with benchmark ratios
  4. Interpret ratios to draw conclusions

Goals of Ratio Analysis

  • Evaluate a company's financial performance
  • Identify financial trends and patterns
  • Compare financial performance of different companies within the same industry
  • Identify strengths and weaknesses in a company's finances

Benefits of Ratio Analysis

  1. Helps in forecasting and planning
  2. Assists in budgeting
  3. Reveals efficiency levels
  4. Effective communication tool
  5. Regulates performance and cost
  6. Facilitates inter-firm comparison
  7. Indicates liquidity and solvency positions
  8. Reveals overall profitability
  9. Aids in decision-making
  10. Simplifies financial statements
  11. Promotes a proactive approach