Welcome to the Investors Trading Academy talking
glossary of financial terms and events. Our word of the day is “Ratio Analysis”
Ratio analysis is the single most important technique of financial analysis in which quantities
are converted into ratios for meaningful comparisons, with past ratios and ratios of other firms
in the same or different industries. Ratio analysis determines trends and exposes strengths
or weaknesses of a firm. A sustainable business and mission requires
effective planning and financial management. Ratio analysis is a useful management tool
that will improve your understanding of financial results and trends over time, and provide
key indicators of organizational performance. Managers will use ratio analysis to pinpoint
strengths and weaknesses from which strategies and initiatives can be formed. Funders may
use ratio analysis to measure your results against other organizations or make judgments
concerning management effectiveness and mission impact.
Ratio Analysis is a form of Financial Statement Analysis that is used to obtain a quick indication
of a firm’s financial performance in several key areas. The ratios are categorized as Short-term
Solvency Ratios, Debt Management Ratios, Asset Management Ratios, Profitability Ratios, and
Market Value Ratios. Ratio Analysis as a tool possesses several
important features. The data, which are provided by financial statements, are readily available.
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. Because Ratio Analysis is based upon accounting
information, its effectiveness is limited by the distortions which arise in financial
statements due to such things as Historical Cost Accounting and inflation. Therefore,
Ratio Analysis should only be used as a first step in financial analysis, to obtain a quick
indication of a firm’s performance and to identify areas which need to be investigated
further.