Every business undertaking is an amalgamation of numerous interlinked aspects. A businessman cannot smoothly manage his business without gauging the different aspects of its operations. Finance is one of the pivotal parts of your business operations. Garnering the right idea about the monetary affairs of your business entity is paramount for you as business owners.

You need to devise robust strategies as part of the financial planning process of your business. Making an effective plan to handle the monetary resources of your business requires some essential inputs. A fundamental part of the process of understanding the financial status of an entity is ratio analysis. If you check out most corporations’ financial statements, you shall discover an in-depth ratio analysis of crucial financial items. Accountants worldwide primarily rely on the method of calculating and analyzing the ratios of a business entity. It helps them to deduce vital information about business performance.

We shall look into some of the necessary details of ratio analysis and its importance for entrepreneurs in making pragmatic business decisions.

What is ratio analysis?

Ratio analysis involves the process of comparing and examining the various line-items of an entity’s financial statements. It helps to gain useful information about liquidity, profitability, solvency, and operational efficiency.

Ratios generally refer to the comparison of two numerical values. It represents the correlation between any two given values. Financial ratios use different line-items that are part of the income statement or the balance sheet of a business.

Trend Analysis:

Entities can undertake ratio analysis on a comparative basis over different periods to know their performance level over time.

Analysis using industry comparison:

One can also compare their entity’s ratios with the average values of its relevant industry. Many accountants even undertake an evaluation of the values of different financial ratios between two business counterparts.

Most professionals use various ratios in combination with each other to derive updates about the financial standing of a concern.

What are the main categories of ratios that accountants use to analyze the financial position of an entity?

Every type of financial ratio that you calculate gets classified into a category. We mostly do such categorization based on the nature of the line-item used for calculation and the ratio’s application.

Major categories of financial ratios

Here is a look of some of the prominent financial ratios that accountants use to analyze an enterprise’s financial performance.

  1. Liquidity ratios
  2. Profitability ratios
  3. Solvency ratios
  4. Coverage ratios
  5. Turnover ratios
  6. Leverage ratios

What are the notable financial ratios which can assist business entities in better decision-making?

We shall now delve into comprehending some of the widely-used financial ratios that help the management attain a clearer picture of their financial standing.

Debt-equity ratio

This ratio shows the correlation between the amount of debt a business concern owes to the amount of equity held in that concern. The more the amount of external debt, the more is the risk for the business. Hence, this ratio acts as a parameter to keep the borrowings of a company under check.

Inventory turnover ratio

The inventory of the products lying unsold is highly undesirable for any business. The inventory turnover ratio helps in determining the duration taken for the complete sale of your stock. One can calculate it using net sales of a period divided by the average inventory value. A low inventory turnover indicates excess investment in unsold inventory.

Price-to-earnings ratio

The market value of a corporation’s shares will mostly vary from the actual amount determined using the actual business revenue. The price-to-earnings ratio compares a company’s market share price to its reported earnings per share. It acts as an indicator of whether your entity’s shares are undervalued or overvalued in the market.

Current ratio

Liquidity is an essential factor for an entity’s operations. The current ratio indicates the amount of current assets divided by the current liabilities of a given period. The ratio helps to know the sufficiency of liquid assets to cover the immediate obligations of a business.

Dividend payout ratio

The amount of dividend an entity pays out in relation to its net income gives us the dividend payout ratio. Simply put, it is the percentage of earnings shared with the shareholders. A low dividend payout ratio means that the dividend payment is lesser than the net profits.

Days sales outstanding ratio

The timely inflow of sales revenue is vital for operating your business smoothly. The days sales outstanding ratio showcases the average time credit sales take to convert into cash for a given period. Accountants mostly calculate this ratio every month using accounts receivable divided by the average daily sales.

Gross profit ratio

This profitability ratio determines the relationship between gross profit and net sales revenue. Gross profit refers to business profits before the deduction of indirect administrative expenses. It is a parameter to evaluate the performance of a concern’s production and sales.

Net profit ratio

It is another profitability ratio that considers the correlation between the profits after tax generated and the entity’s net sales for a given period. It is an excellent metric to assess the overall functioning of a business.

Return on assets ratio

The ratio is a measure to know the profits a business earns using the total assets employed. It tells us about the efficiency of your operations to generate proper returns from the economic resources invested.

How does appropriate ratio analysis help in undertaking profitable decisions for a business entity?

Ratio analysis can act as an indispensable tool to review the financial pulse of your venture. The points below highlight the importance of ratio analysis in initiating profitable decisions for your business.

  1. Enables a better understanding of the business profitability

Using the profitability ratios, you can assess how profitable your venture has proved. Ratios like the gross profit ratio and the net profit ratio showcase your firm’s ability to convert sales into profits. Using the information, you can make more effective decisions about the sales and production of your enterprise.

  1. Lucidly outlines the liquidity position of the business

The capacity to pay our short-term liabilities is immensely imperative for seamless operations. Using liquidity and turnover ratios, you can judge the liquidity position of your entity.

  1. Alerts you about financial risks of the entity

All business owners need to remain aware of any impending financial risks to their firm. Ratios such as leverage ratios provide a glimpse of the firm’s dependency on external loans, which come with the risk of non-repayment. If one gets a sense of any financial risk well in advance, he can take necessary corrective action to prevent future troubles.

  1. Facilitates proper comparisons

Ratios aid in easier inter-firm and intra-firm comparisons. Businessmen can use them to evaluate their financial standing in contrast to previous periods. They can even check their performance levels against industry benchmarks.

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