Advantages of Ratio Analysis

Ratio analysis, when done properly, improves your understanding of how efficiently a business is being run. The numerical relationships revealed by ratios throw light on many hidden aspects of the business. They help you spot both problem areas and bright spots. Problem areas need management attention; bright spots can be polished further for even better results.

It is crucial to remember that ratios are a means to an end, not the end themselves. Their role is essentially indicative — they act as a whistle-blower, pointing out where to look, but not giving the final verdict.

Here are the key advantages of ratio analysis, as summarised in the textbook:

1. Helps to understand the efficacy of decisions: Ratio analysis tells you whether the firm has taken the right kind of operating, investing, and financing decisions. It shows how far these decisions have helped in improving the firm's performance.

2. Simplifies complex figures and establishes relationships: Ratios simplify complex accounting figures and bring out their relationships. They help summarise financial information effectively, allowing you to assess managerial efficiency, the firm's creditworthiness, earning capacity, and more.

3. Helpful in comparative analysis: Ratios are not meant to be calculated for just one year. When you place figures from many years side by side, ratios help explore the trends visible in the business. Knowing the trend is very useful for making projections about the business's future.

4. Identification of problem areas: As mentioned earlier, ratios help identify both problem areas (which need more attention) and bright areas (which need polishing for even better results).

5. Enables SWOT analysis: Ratios help explain the changes occurring in the business. This information helps management understand current threats and opportunities, allowing the business to conduct its own SWOT (Strength-Weakness-Opportunity-Threat) analysis. …