Objectives of Ratio Analysis

Ratio analysis is not just about calculating numbers — it is the bridge between raw financial data and meaningful business insight. The textbook positions it as an indispensable part of interpreting the results shown by financial statements. Without ratio analysis, a balance sheet or profit and loss account remains a collection of figures; with it, those figures start telling a story about the business's health, weaknesses, and future possibilities.

The core idea is that ratio analysis involves regrouping data by applying arithmetical relationships. But the textbook is careful to point out that while the calculation is arithmetic, the interpretation is complex. It demands a fine understanding of how financial statements are prepared — the rules, conventions, and accounting policies behind the numbers. A ratio is only as good as the data that feeds it.

Once done effectively, ratio analysis provides a lot of information that helps the analyst in five specific ways.

1. To know the areas of the business which need more attention

Ratios act like diagnostic tools. A low current ratio, for instance, immediately flags a potential liquidity problem. A high debt-equity ratio signals excessive reliance on borrowed funds. Instead of guessing where the trouble lies, the analyst can pinpoint the exact area — inventory management, collection of receivables, or long-term financing — that requires corrective action.

2. To know about the potential areas which can be improved with effort in the desired direction

This is the positive side of the same coin. Ratios not only reveal problems but also highlight strengths that can be leveraged. If the gross profit ratio is healthy but the net profit ratio is weak, the analyst knows that the issue lies in operating expenses, not in pricing or production. Effort can then be directed specifically at cost control.

3. To provide a deeper analysis of the profitability, liquidity, solvency and efficiency levels in the business

This is the heart of ratio analysis. Financial statements give absolute figures — profit of ₹5,00,000, total assets of ₹50,00,000. Ratios convert these into relative measures that allow comparison across time and across companies. Profitability ratios (like return on capital employed) tell you how well the business generates earnings. Liquidity ratios (like the current ratio) tell you whether it can meet short-term obligations. Solvency ratios (like debt-equity) tell you about long-term financial stability. Efficiency ratios (like inventory turnover) tell you how well assets are being used.

4. To provide information for making cross-sectional analysis by comparing performance with the best industry standards

A single ratio in isolation means little. A current ratio of 2:1 might be excellent for a manufacturing firm but poor for a retail business. By comparing the firm's ratios with industry averages or with the best-performing competitors (benchmarking), the analyst can judge whether the business is above or below par. This cross-sectional analysis is one of the most powerful uses of ratios.

5. To provide information derived from financial statements useful for making projections and estimates for the future …