Ratio Analysis – Advantages and Limitation of ratio analysis.

Ratio Analysis in Financial Management

Ratio Analysis is a quantitative technique used to assess a company’s financial performance by analyzing data from its financial statements. Ratios help in comparing companies, identifying trends, and making informed financial decisions.

Importance of Ratio Analysis:

Assesses financial health and stability of a business
Helps stakeholders make informed decisions
Assists in performance comparisons over time or with peers

Types of Ratios

1. Liquidity Ratios

These measure a company's ability to meet short-term obligations.

Current Ratio = Current Assets / Current Liabilities

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

2. Solvency (Leverage) Ratios

These indicate a firm’s ability to meet long-term obligations.

Debt to Equity Ratio = Total Debt / Shareholders’ Equity

Interest Coverage Ratio = EBIT / Interest Expense

3. Profitability Ratios

These assess the company’s ability to generate profit relative to revenue, assets, or equity.

Net Profit Margin = Net Profit / Revenue × 100

Return on Assets (ROA) = Net Income / Total Assets × 100

Return on Equity (ROE) = Net Income / Shareholder’s Equity × 100

4. Efficiency (Activity) Ratios

These measure how effectively a company uses its assets.

Inventory Turnover = Cost of Goods Sold / Average Inventory

Receivables Turnover = Net Credit Sales / Average Accounts Receivable

Asset Turnover = Net Sales / Average Total Assets

Conclusion

Ratio analysis provides crucial insights into financial performance and helps stakeholders evaluate the profitability, efficiency, solvency, and liquidity of a business. When used consistently and alongside other tools, it becomes a powerful decision-making aid.