Significance or Importance of Ratio Analysis:: - It Helps in Evaluating The Firm's Performance

SIGNIFICANCE OR IMPORTANCE OF RATIO ANALYSIS:
Ratio analysis is a widely used tool of financial analysis. It is defined as the

systematic use of ratio to interpret the financial statements so that the strength and
weaknesses of a firm as well as its historical performance and current financial
condition can be determined. The term ratio refers to the numerical or quantitative
relationship between two variables.
• It helps in evaluating the firm’s performance:
With the help of ratio analysis conclusion can be drawn regarding several
aspects such as financial health, profitability and operational efficiency of the
undertaking. Ratio points out the operating efficiency of the firm i.e. whether the
management has utilized the firm’s assets correctly, to increase the investor’s
wealth. It ensures a fair return to its owners and secures optimum utilization of
firms assets
• It helps in inter-firm comparison:
Ratio analysis helps in inter-firm comparison by providing necessary data.

An inter-firm comparison indicates relative position. It provides the relevant data
for the comparison of the performance of different departments. If comparison
shows a variance, the possible reasons of variations may be identified and if results
are negative, the action may be initiated immediately to bring them in line.
• It simplifies financial statement:
The information given in the basic financial statements serves no useful

Purpose unless it is interrupted and analyzed in some comparable terms. The ratio
analysis is one of the tools in the hands of those who want to know something
more from the financial statements in the simplified manner.
• It helps in determining the financial position of the concern:
Ratio analysis facilitates the management to know whether the firm’s

financial position is improving or deteriorating or is constant over the years by
setting a trend with the help of ratios The analysis with the help of ratio analysis
can know the direction of the trend of strategic ratio may help the management in
the task of planning, forecasting and controlling.
• It is helpful in budgeting and forecasting:
Accounting ratios provide a reliable data, which can be compared, studied

and analyzed. These ratios provide sound footing for future prospectus. The ratios
can also serve as a basis for preparing budgeting future line of action.
• Liquidity position:
With help of ratio analysis conclusions can be drawn regarding

the Liquidity position of a firm. The liquidity position of a firm would
be satisfactory if it is able to meet its current obligation when they
become due. The ability to meet short term liabilities is reflected in the
liquidity ratio of a firm.
• Long term solvency:
Ratio analysis is equally for assessing the long term financial ability of the
Firm. The long term solvency s measured by the leverage or capital structure and
profitability ratio which shows the earning power and operating efficiency,
Solvency ratio shows relationship between total liability and total assets.
• Operating efficiency:
Yet another dimension of usefulness or ratio analysis, relevant

from the View point of management is that it throws light on the
degree efficiency in the various activity ratios measures this kind of
operational efficiency.
• Help in investment decisions:
It helps in investment decisions in the case of investors and lending decisions in

the case of bankers etc.
CLASSIFICATION OF RATIOS:
Different ratios are used for different purpose these ratios can
be grouped into various classes according to the financial activity.
Ratios are classified into four broad categories.
1. Liquidity Ratio
2. Leverage Ratio
3. Profitability Ratio
4. Activity Ratio
1. Liquidity Ratio:
Liquidity ratio measures the firm’s ability to meet its

current obligations i.e. ability to pay its obligations and when they become
due. Commonly used ratios are:
• Current ratio:
Current ratio is the ratio, which express relationship between current

asset and current liabilities. Current asset are those which can be converted
into cash within a short period of time, normally not exceeding one year. The
current liabilities which are short- term maturing to be met.
Current ratio
Current Asset = ---------------------
Current liabilities
• Acid test ratio:
The acid test ratio is a measure of liquidity signed to overcome the Defect of
current ratio. It is often referred to as quick ratio because it is a measurement of
firm’s ability to convert its current assets quickly into cash in order to meet its
current liabilities.
Current asset -Inventories

Acid test ratio = -------------------------------
Current liabilities
2. Leverage or capital structure ratio:
Leverage or capital structure ratios are the ratios, which indicate the relative
interest of the owners and the creditors in an enterprise. These ratios indicate the
funds provided by the long-term creditors and owners.
To judge the long term financial position of the firm following ratios are applied.
1. Debt –equity ratio:
Debt-equity ratio which expresses the relationship between debt and equity this
ratio explains how far owned funds are sufficient to pay outside liabilities. It is
calculated by following formula
Long term +short term debts +current liabilities

Debt equity ratio= -----------------------------------------------------------
Net worth
2. Total Debt ratio:
This ratio explains how far owned and borrowed funds are sufficient to pay debt of
the firm
Long term+short term borrowing+current liabilities

---------------------------------------------------------------
Capital employed
3. Profitability ratio:
Profitability ratio are the best indicators of overall efficiency of the business
concern, because they compare return of value over and above the value put into
business with sales or service carried on by the firm with the help of assets
employed. Profitability ratio can be determined on the basis of:
• Sales
• Investment
• Profitability ratios related to sale:
1. Gross profit to sales ratio:
The gross profit to sales ratio establishes relationship between

gross profit and sales to measure the relative operating efficiency of
the firm to reflect pricing policy
Sales-cost of goods sold

Gross profit to sales ratio = ------------------------------ * 100
Sale
2. Net profit margin:
The net margin indicates the management’s ability to earn sufficient profit on sales
to earn sufficient profit on sales not only to cover all revenue operating expenses of
the business, the cost of borrowed funds and the cost of goods or servicing, but
also to have sufficient margin to pay reasonable comparison to shareholders on
their contributions to the firm.
Net profit after tax and interest

Net profit margin= ------------------------------------- *100
Sales
3. Profitability ratios related to investments:
a. Return on assets: The profitability ratio here measures the relationship between
net Profit and assets.
Net profit after tax

Return on assets= ------------------------
Fixed assets
b. Return on capital employed:
Net profit after taxes

Return on capital employed= ------------------------
Total capital employed
3. Activity ratio:
Activity ratio are sometimes are called efficiency ratios. Activity ratios are
concerned with how efficiency the assets of the firm are managed. These ratios
express relationship between level of sales and the investment in various assets
inventories, receivables, fixed assets etc.
The important activity ratios are as follows:
1. Inventory turnover ratio:
Raw materials consumed

Inventory turnover ratio = ---------------------------------------
Average stock of raw materials
2. Debt turnover ratio:
This ratio shows quickly debtors are converted into cash
Total sales
Debt turnover ratio = ---------------
Debtors
3. Average collection period ratio:
This ratio indicates how quickly the inventory is converted into cash.
Days in a year
= --------------------
Debtor’s turnover
4. Working capital turnover ratio:
This ratio shows the number of times the working capital turns in trading
transaction. If it has an increasing trend over the previous year it shows that the
working capital is being used efficiently.

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SIGNIFICANCE OR IMPORTANCE OF RATIO ANALYSIS:

Ratio analysis is a widely used tool of financial analysis. It is defined as the

• It helps in evaluating the firm’s performance:

• It helps in inter-firm comparison:

Ratio analysis helps in inter-firm comparison by providing necessary data.

• It simplifies financial statement:

The information given in the basic financial statements serves no useful

• It helps in determining the financial position of the concern:

Ratio analysis facilitates the management to know whether the firm’s

Accounting ratios provide a reliable data, which can be compared, studied

With help of ratio analysis conclusions can be drawn regarding

• Long term solvency:

Yet another dimension of usefulness or ratio analysis, relevant

• Help in investment decisions:

It helps in investment decisions in the case of investors and lending decisions in

Liquidity ratio measures the firm’s ability to meet its

Current ratio is the ratio, which express relationship between current

• Acid test ratio:

Current asset -Inventories

2. Leverage or capital structure ratio:

1. Debt –equity ratio:

Long term +short term debts +current liabilities

2. Total Debt ratio:

Long term+short term borrowing+current liabilities

1. Gross profit to sales ratio:

The gross profit to sales ratio establishes relationship between

Sales-cost of goods sold

2. Net profit margin:

Net profit after tax and interest

3. Profitability ratios related to investments:

Net profit after tax

b. Return on capital employed:

Net profit after taxes

The important activity ratios are as follows:

1. Inventory turnover ratio:

Raw materials consumed

2. Debt turnover ratio:

This ratio shows quickly debtors are converted into cash

3. Average collection period ratio:

4. Working capital turnover ratio:

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