A comparative study of the relationship, between various items of financial statements, expressed as ratios, reveals the profitability, liquidity, solvency as well as the overall financial position of the enterprises.
Ratio analysis helps to analyze and understand the financial health and trend of a business, its past performance makes it possible to have forecast about future state of affairs of the business. Interfere comparison and intrafirm comparison becomes easier through the analysis. Past performance and future projections could be reviewed through the ratio analysis easily. Management uses the ratio analysis in exercising control in various areas viz. budgetary control, inventory control, financial control etc. and fixing the accountability and responsibility of different departmental heads for accelerated and planned performance. It is useful for all the constituents of the company as discussed under:
- Management: Management is interested in ratios because they help in the formulation of policies, decision-making and evaluating the performances and trends of the business and its various segments.
- Shareholders: With the application of ratio analysis to financial statements, shareholders can understand not only the working and operational efficiency of their company, but also the likely effect of such efficiency on the net worth and consequently the price of their shares in the Stock Exchange. With the help of such analysis, they can form opinion regarding the effectiveness or otherwise of the management functions.
- Investors: Investors are interested in the operational efficiency, earning capacities and ‘financial health’ of the business. Ratios regarding profitability, debt-equity, fixed assets to net worth, assets turnover, etc., are some measures useful for the investors in making decisions regarding the type of security and industry in which they should invest.
- Creditors: Creditors can reasonably assure themselves about the solvency and liquidity position of the business by using ratio-analysis. Such analysis helps to throw light on the repayment policy and capability of an enterprise.
- Government: The Government is interested in the ‘financial health’ of the business. Carefully worked ratios will reflect the policy of the management and its consistency or otherwise with the overall regional and national economic policies. Such ratios help in better understanding of cost-structures and may justify price controls by the Government to save the consumers.
- Analysts: Ratio analysis is the most important technique available to the financial analysis to study the financial statements to compare the progress and position of various firms with each other and vis-a-vis the industry.