Financial ratio analysis helps a business in a number of ways. The importance and advantages of financial ratios are given below:
(i) Ratios help in analyzing the performance trends over a long period of time.
(ii) They also help a business to compare the financial results to those of competitors.
(iii) Ratios assist the management in decision making.
(iv) They also point out problem and weak areas along with the strength areas.
(v) Ratios to help to develop relationships between different financial statement items.
(vi) Ratios have the advantage of controlling for differences in size. For example, two businesses may be quite different in size but can be compared in terms of profitability, liquidity, etc., by the use of ratios.
Users of Financial Ratios:
Financial ratio analysis is aimed to assess the financial performance and determine the financial position of an organization through its profitability, liquidity, activity, leverage and other relevant indicators. There are many groups and individuals with diverse and conflicting interests but want to know about the business performance or position. In the following table major users of financial statements with their areas of interest are described.
(1) Bankers and Lenders: Use profitability, liquidity and investment because they want to know the ability of the borrowing business in regular scheduled interest payments and repayments of principal loan amount.
(2) Investors: Use profitability and investment because they are more interested in profitability performance of business and safety & security of their investment and growth potential of their investment.
(3) Government: Use profitability because government may use profit as a basis for taxation, grants and subsidies.
(4) Employees: Use profitability, liquidity and activity because employees will be concerned with job security, bonus and continuance of business and wage bargaining.
(5) Customers: Use liquidity because customers will seek reassurance that the business can survive in the short term and continue to supply.
(6) Suppliers: Use liquidity because suppliers are more interested in knowing the ability of the business to settle its short-term obligations as and when they are due.
(7) Management: Use all ratios because management is interested in all aspects i.e., both financial performance and financial condition of the business.