The importance of ratio analysis are:- 1. Aid to Measure General Efficiency 2. Aid to Measure Financial Solvency 4. Facilitate Decision-Making 5. Aid in Corrective Action 6. Aid in Intra Firm Comparison 7. Act as a Good Communication 8. Evaluation of Efficiency 9. Effective Tool 10. Detection of Unfavourable Factors.
1. Aid to Measure General Efficiency:
Ratios enable the mass of accounting data to be summarised and simplified. They act as an index of the efficiency of the enterprise. As such they serve as an instrument of management control.
2. Aid to Measure Financial Solvency:
Ratios are useful tools in the hands of management and other concerned to evaluate the firms performance over a period of time by comparing the present ratio with the past ones. They point out firm’s liquidity position to meet its short term obligations and long term solvency.
3. Aid in Forecasting and Planning:
Ratio analysis is an invaluable aid to management in the discharge of its basic function such as planning, forecasting, control etc. The ratios that are derived after analysing and scrutinizing the past result, helps the management to prepare budgets to formulate policies and to prepare the future plan of action etc.
4. Facilitate Decision-Making:
It throws light on the degree of efficiency of the management and utilisation of the assets and that is why it is called surveyor of efficiency. They help management in decision-making.
5. Aid in Corrective Action:
Ratio analysis provides inter-firm comparison. They highlight the factors associated with successful and unsuccessful firms. If comparison shows an unfavourable variance, corrective actions can be initiated. Thus, it helps the management to take corrective action.
6. Aid in Intra Firm Comparison:
Intra firm comparisons are facilitated. It is an instrument for diagnosis of financial health of an enterprise. It facilitates the management to know whether the firm’s financial position is improving or deteriorating by setting a trend with the help of ratios.
7. Act as a Good Communication:
Ratios are an effective means of communication and play a vital role in informing the position of and progress made by the business concern to the owners and other interested parties. The communications by the use of simplified and summarised ratios are more easy and understandable.
8. Evaluation of Efficiency:
Ratio analysis is an effective instrument which, when properly used, is useful to assess important characteristics of business—liquidity, solvency, profitability etc. A study of these aspects may enable conclusions to be drawn relating to capabilities of business.
9. Effective Tool:
Ratio analysis helps in making effective control of the business- measuring performance, control of cost etc. Effective control is the keynote of better management. Ratio ensures secrecy.
10. Detection of Unfavourable Factors:
Analysis of financial statements enables the analyst to find out the soundness or otherwise of a business. If the analysis reveals financial unsoundness, the factors responsible for such unsoundness can be separated and corrective action taken without loss of time.
Figures, in their absolute forms, shown in the financial statements are neither significant nor able to be compared. In fact, they are dump. But ratios have the power to speak.