Ratio analysis is a beneficial tool used in a company. Many people need to be made aware of the benefits of ratio analysis also what are the advantages of ratio analysis. It defines that the decisions taken in a company are right or wrong to some extent. Ratio analysis can compare various firms over a short period. It answers every question about the company’s stability, turnover, etc. In this article, we will briefly describe the advantages and limitations of ratio analysis, its objectives, and all the benefits of ratio analysis that a firm experiences. In this article, we will briefly discuss what are the advantages of ratio analysis.
What is Ratio Analysis?
Ratio analysis is a quick analysis of various things that appear in a firm and provide information about the business’s financial status, such as profit and loss, Balance sheet, and fund flow statement. It even compares the financial situation of one year to another. The main advantages of ratio analysis are to keep descriptive data about the company so that every person engaged with the firm can understand the status easily and more comfortably. If we appropriately use ratio analysis, it has various advantages and limitations of ratio analysis. It will help the firm maintain its strengths and work on its weakness. There are multiple benefits of ratio analysis which will help the firm become more organized, and we can see the company’s performance as well. Let’s discuss more about what are the advantages of ratio analysis.
Steps for Ratio Analysis
Ratio analysis is a very beneficial tool for any business, and there are various advantages and limitations of ratio analysis. However, four main steps to achieve a ratio analysis statement are:
- The first step is to collect all the essential information regarding the business’s financial statement.
- After collection, construct ratios with various accounting figures.
- After constructing ratios, compare them with the standard ratios formed before calculation. You can even compare the new data with the previous year’s data to understand the firm’s growth.
- Making a final result for all the compared ratios, conclude the firm’s financial statement.
Advantages of Ratio Analysis
Ratio analysis is a comprehensive tool used to measure the financial statement of firms. However, there are various advantages and limitations of ratio analysis.
1. Forecasting and Planning
Ratio analysis is an essential tool, and ratio analysis has many benefits. However, the first benefit of ratio analysis is that it helps predict the nature and the planning of the plans in a firm. When we compute a ratio of a year, then we can expect the profit, loss, cash flow, and other things about the financial statement. However, with the help of ratio analysis, we can opt for better plans to protect the firm from unusual crises. And we can even plan our further steps for better achievements. Also, people need clarification about the advantages and limitations of ratio analysis.
Ratio analysis helps us to make a budget plan about the essential needs of the business. Once we calculate the ratio analysis, we can prepare a brief budget for other firm expenses. We can calculate ratios with the help of accounting ratios.
3. Measurement of Operating Efficiency
Ratio analysis also helps us to measure the efficiency that a business holds. We can calculate all the assets and profits to calculate the total efficiency of the year. The efficiency of the company may vary every year. Not only the profits, but we can even measure the losses that occur in a business—usually, the solvency results from not using the frozen assets efficiently.
Ratio analysis is essential as It helps communicate the firm’s financial status. It keeps us more attentive toward all the profits and losses in a business. Through ratio analysis, we can speak about the company’s future goals. This is the most essential among the advantages of ratio analysis for many people.
5. Indication of Liquidity Position
Ratio analysis helps us provide information about the business’s liquidity position. With the help of ratio analysis, we can calcite how much cash is available in the firm and how we can liquidate it. Many people need to be made aware of the benefit of ratio analysis. It also predicts how we can pay off all the short-term debts and loans of the business.
Read More: What are the Sources of Business Finance
Limitations of Ratio Analysis
Here are various limitations of ratio analysis are :
1. Limitation of Financial Statements
Ratios are calculated with the help of a financial statement for a particular period. However, these values may differ or can be bluffed sometimes. So sometimes, due to limitations of numbers, the financial report also needs to improve, which results in inaccurate data.
2. Historical Information
in ratio analysis, all the data is based on historical information rather than the present situation. It often results in a wrong estimation, and the data is not exact. However, historical information needs to be improved in predicting future expenses.
3. Lack of a Standard of Comparison
The ultimate limitation of ratio analysis is that you cannot imagine an ideal ratio. We often have to face the problem of standards and expectations. At some points, the firm has different results than we expected.
4. Window Dressing
Window d5ressing helps to show the analysis results so that they seem more attractive and natural than the actual one. However, this thing often needs to be clarified about the firm’s position. However, we cannot calculate the natural result of the firm’s success with window dressing.
5. Change in the Price Level
Another area for improvement of ratio analysis is that it needs to show the fundamental price change. All the fixed assets available in the firm are calculated based on actual price; however, when the market fluctuates and the price changes, it doesn’t depict the real difference.
The Objective of Ratio Analysis
Ratio analysis is an essential tool in any business. It helps to interpret the company’s financial statement to all the investors, stakeholders, owners, etc. Maintaining complete knowledge about the firm is necessary for everyone as it helps us explain the business’s status. However, ratio analysis is essential for guiding the firm and other things.
If you’re a business owner and want to measure all the pros and cons of your business, then nothing can be much better than ratio analysis. It helps you to get more brief information about the financial statement of your business. We have already discussed the objectives, advantages, and limitations of ratio analysis and all the benefits you have experienced. I hope you’ve got your answers about the advantages of ratio analysis.
What are the Advantages of Ratio Analysis – FAQs
What is the source of data for ratio analysis?
Ans. The source of data for ratio analysis is the financial statement. All the deals and balances are concluded together to form financial information.
Which chart is used for ratio analysis?
Ans. The line chart is used for ratio analysis.
Is ratio analysis vertical or horizontal?
Ans. The ratio analysis contains horizontal analysis in which you can compare all the data and figures to get the exact results.
What is the scope of ratio analysis?
Ans. The ratio analysis helps us provide information about the business’s financial statement. However, it also keeps us more intact with the company’s liquidity, cash flow, and other aspects.
Can ratio data be negative?
Ans. No, having any harmful data in ratio analysis is impossible.