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What Is the Importance of Ratio Analysis?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 12 August 2014
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The importance of ratio analysis is derived from its usefulness as a tool for the assessment of the state of a business by the owners, prospective investors, and people and institutions who may be considering lending money to the business. Ratio analysis is used to calculate or analyze the financial statements generated from a company in a given period. This information is invaluable in terms of its use as an indicator of the position of a company in a competitive financial market.

One of the examples of the role of ratio analysis is its importance as a means for a company to perform an internal evaluation of its performance over a stated period. The information gathered during the ratio analysis allows the company to know whether it has been operating at a profit or a loss as well as the percentage of the profit margin. When the company discovers that it has been operating at a loss, the ratio analysis will allow it to pinpoint the exact sources of the loss. This will allow the business to decide on the best approach for addressing the loss.

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Another importance of ratio analysis is the fact that it allows a company to compare its performance with that of other companies in the same industry. In the case of huge corporations with different subsidiaries and branches in various locations around the globe, the importance of ratio analysis is clear. Such companies can compare the result of the ratio analysis of the different subsidiaries with the aim of finding out which ones are performing better than the rest. This type of an analysis can be applied toward allocating necessary resources to the under-performing subsidiaries in a more efficient manner.

Also, the importance of ratio analysis can be seen in the way it gives potential investors a quick snap shot of the financial condition of a business. Such information may help the investor decide if the business will be profitable or not. If the results of the ratio analysis point toward strong profits, the investor may decide to invest in the business. In the same sense, if the business is not performing well, a prospective buyer may use this information as a bargaining chip to bid a low price for the business.

When a bank is considering the possibility of granting a business loan, one of the initial factors it looks at is the ratio analysis of the business. The record of cash inflow and outflow as well as posted profits will help the bank make an informed decision. A positive trend in the ratio analysis is an indication that the business is capable of paying back the loan.

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