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Importance of Ratio Analysis

The ratio analysis is an important tool of financial analysis for different users fo the financial or accounting information. Ratios present the facts on a comparative basis by relating one set of figures with other set of figures either in the same financial statement, e.g. income statement or balance sheet or figures of different financial statements, that is, income statement and the balance sheet. The importance of ratio analysis can be summarized by emplacing its impact on different users as given below:

(i)    Liquidity position: The short-term creditors are more interested in the liquidity position of the firm in the sense that their money would be repaid on due dates. The ability of the firm to pay short-term obligations like interest on theory term loan or the principal amount can be found by computing liquidity ratios, e.g., current ratio and quick ratio.

(ii)    Long-term solvency: This required by long-term creditors, security analysts and the present and potential shareholders of the company. These persons can know with the help of capital structure ratios such as debt-equity ratio, leverage ratio, profitability ratios, etc. what sources fo long-terms funds are employed, a  and what is their relative position, i.e., percentage of various sources of finance. They can also focus on the earning power of the company in order to and out the interest payment position and also the repayment of the principal amount.

(iii)    Operating efficiency: This aspect of ratio analysis is important for management which can determine how effectively the assets are being used. Activity ratios such as stock turnover, debtors turnover, fixed assets turnover etc. are all helpful in assessing the operational efficiency. in fact the solvency of the firm is dependent upon the sales income generated from the use of various assets. The management can use these ratios with the standard ratios; by comparing the ratios fo the current year with those fo the past periods and by comparing the ratios fo the firm with those of other firms in the same industry.

(iv)    Overall profitability: Different users of accounting information make use of specific ratios to meet or satisfy their requirements. But the management is always interested int eh overall profitability and effect of the business enterprise. For example, it has to be careful about the ability of the firm to pay the short-term creditors as well as long-term creditors. Furthered, the firm has to ensure a reasonable rate of return to the shareholders and also the optimum utilization of its assets.

(v)    Trend analysis: Ratio analysis is important not for the current period but what has happened in the past. It can be found whether the financial position has been improving or worsening or has remained constant over the years. This is possible by making use f trend analysis of ratios for a number of years. Trend analysis will guide the analysts to know whether the movement is favourable or unfavorable. For example, the profitability position of the firm may be favorable for the present, it has definitely declined when compared with the past.

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