Ratio analysis is used to evaluate relationships among financial statement items. The ratios are used to identify trends over time for one organization or to compare two or more organizations at one point in time. Ratio analysis focuses on three key aspects of a business: liquidity, profitability, and solvency.
Ratio Analysis is an important tool for any business organization. The computation of ratios facilitates the comparison of firms which differ in size. Ratios can be used to compare a firm’s financial performance with industry averages. In addition, ratios can be used in a form of trend analysis to identify areas where performance has improved or deteriorated over time.
Accounting Ratios
An absolute figure often does not convey much meaning. Generally, it is only in the light of other information that significance of a figure is realized. A weighs 70 kg Is he fat? One cannot answer this question unless one knows A’s age and height. Similarly, a company’s profitability cannot be known unless together with the amount of profit and the amount of capital employed. The relationship between the two figures expressed arithmetically is called a ratio. The ratio between 4 and 10 is 0.4 or 40% or 2:5. “0.4″,”40%” and “2:5″ are ratios. Accounting ratios are relationships, expressed in arithmetical terms, between figures which have a cause and effect relationship or which are connected with each other in some other manner.
