Most industries have a set of tools or a path which the professionals in that trade use to deliver the promised outcome. Ratio analysis are essentially quantitative tools used by people working in the financial profession, to analyse sets of financial information. This information is contained in the establishment's financial statements.
Understanding Ratio Analysis
Ratio analysis is based on the headers from the financial statement like the balance statement, income statement, cash flow statement etc…, ratios of either one of them or with a permutation of some items is compared with another combination, and then calculated.
Ratio analysis is basically an evaluation tool to examine various aspects of functioning of a company, understanding its financial operations, like liquidity, efficiency, profitability etc…,
Trend analysis is further done on the ratios to understand if they are declining or refining.
Ratios are usually also compared with different companies falling in the same sector, to understand and run comparative valuations. Ratio analysis thus becomes the foundation of fundamental analysis, further assisting the company to make appropriate investment decisions.
Ratio analysis, to largely put it, can be done under any grouping, as far as the features are comparable. Some common categories are – Ratio analysis by department, industry, period, company, the age of the company, geographical location, ratio analysis for intercompany elements.
Conducting ratio analysis is only half the job done, without words describing them and
assigning meaning to it, the analysis will only be another set of numbers.
In current times there is much-sophisticated accounting software’s that are capable of conduction the ratio analysis.
However, a person in the financial professional is the one who guides and raises the need and importance to do it. Like for example, a financial analyst in investment banking, who manages and reports on investment portfolio will base the investment path on ratio analysis to make informed decisions. The most commonly calculated class of ratios are, investment, profitability, performance, financial liquidity, stock market ratios etc…,
Advantages of Ratio Analysis
- Most numbers found in the financial statements will have no meaning or understanding, hence a financial analyst uses the preferred method of ratio analysis to give meaning to the numbers.
- It helps the heads of a department or of an institution to understand trends, and base projections in the future, for an item from the financial statement, deciding its course.
- After calculating, the investment analyst will be better able to decide to invest in a project or not, thus Ratio analysis assists in better decision making.
- Ratio analysis can be done across sectors within the industry for financial factors, it thus helps compare one’s growth and performance with another, giving a parameter of performance.
- Enhancing a performance of a department, becomes easy, performing ratio analysis will throw light on the health of a department, if it is excelling or needs improvement, and if so, how can it be financially supported. Such a report card can be made with the help of ratio analysis.
Ratio analysis help flag early signs of warning, of either a fall or deterioration or an improvement in the financial performance of a company or an institution or individual investments. Analysts continuously work in understanding the impact and raising alarms if required for the company or individual stocks. Over analysis could also have a negative impact, as there is an availability of ratios. A point to remember is that ratio analysis is to make things simpler and not over complicate strategies and investments.