Ratio analysis in Accounting is a technique that aims to convert and compare ratio data in accounts. One can use it in places such as income statements and balance sheets. It helps to determine the liquidity, operational efficiency, and profitability of the business. Ratio Analysis in accounting deals with the analysis of age-line figures from the financial accounts of an organization with a view of giving information on solvency, profitability, liquidity, and efficiency. It is a relative measure to compare one company against the other in the same industry or sector and to also compare the performance of a company in the previous and current financial year. This is an excellent way to keep a tab on your competitors and survey their profits.
Need For Ratio Inspection
Ratio Analysis also helps in gaining market ratio insights. Market Ratio generally implies the knowledge of relative values in the market which is crucial to identify no matter the amount of experience one possesses. Market ratio insights can help determine the sales, and profit strategy of two companies and can give you insights about their future prospects as well. It will also help you understand which stocks you can invest in a company and will provide you with overalldata about your competitors. Market Ratio Analysis is a key part of Ratio Analysis of any venture.
Types Of Ratio Analysis
1. Liquidity Ratios
Liquidity ratio calculation enables one to determine whether a business can efficiently utilize the existing stocks or things that are within a short time, to meet the outstanding obligations when due. It includes the working capital ratio working capital ratio, the quick ratio, and the current ratio.
Frequently Used Accounting Ratios for Liquidity:
Current Assets/Current Liabilities equals the current ratio.
Liquidity ratio calculations are as follows:
Quick Ratio is equal to [Current Liabilities / Current Assets – Inventory – Prepaid Expenses].
2. Ratios of Solvency
Solvency Ratios provide you with the necessary information on the financial and debt possibilities of a company. The solvency ratio is also another tool that gives information as to whether the business concern can repay its credit and other debts or not.
3. Ratios of Profitability
These ratios show the levels of profitability that an organization is likely to achieve given the circumstances.
4. Ratios of Efficiency
Efficiency ratios or activity ratios estimate how effectively a company utilizes assets and liabilities to produce sales and perusing profitability.
5. Ratios of Coverage
The ability of a business to pay off its loans’ interest and other associated responsibilities is gauged by coverage ratios. Two examples of it are the time’s interest earned ratio and the debt-service coverage ratio.
Ratio Analysis In Use
A key financial ratio found in ratio analysis in accounting is the net profit margin. It measures the ability of the company to make money out of the total revenues earned.
Net profit margins are the bottom line measure. It compares how profitable various companies are in the same industry. It is calculated commonly by dividing income available to common stock by the number of shares of stock outstanding. By using this ratio, the investor doesn’t actually have to look at financial documents to be able to compare the level of profitability. If two companies are in the same industry selling products or rendering services, where ABC has a profit margin of 50% while DEF has only 10%.
A corporation may notice that it has access to a plethora of data and information. They can use the data as reference points for its operations. The concept of ratio analysis ensures that the multiple pieces of information they offer are compared objectively, and therefore applied more efficiently. This procedure is of much significance to a company, as it can discover more about how well it is performing in the long run, competitively and by internal targets.
