Ratio analysis comprises the examination of financial information depicted in financial reports, by applying appropriate formulas. Ratio analysis portrays the financial health of the organization. It focuses on four important facets of the firm, being the profitability, efficiency, liquidity and stability. Profitability consists of the ability of the firm to generate revenue in excess of the expenditure incurred. While, efficiency ratios focus more on the aptitude of management to control costs. Liquidity ratios reveal the capability of the corporation to maintain a proper working capital and thus enhance liquid resources in the company.
Stability concerns the financial strength of the company to meet its long-term commitments. A financially stable organization is a firm that holds a sound capital structure sustained by good profits and proper cash flow balances. The use of ratio analysis stems from the information they convey in the aforementioned areas. A constant need that internal users like management and external entities/individuals related to the firm, such as investors, lenders and suppliers have is financial information on the corporation they possess financial interest in.
A very useful element during the decision-making process is relevant and reliable information on the decision at hand. Ratio analysis suits that purpose because they provide financial data on the organization in order to show the financial performance and position of the company and thus aid in attaining an optimal decision. For instance by comparing the ratios of a firm over time or with the industry average one can see the financial progression or regression of the company, together with its financial health in relation to the industry.
Not all the ratios available ought to be adopted during a ratio analysis. The selection of the most applicable ratios depends on the information needed by the intended user. For example, an investor is frequently faced with the decision of either holding the investment, investing more or disposing the investment. In such cases information on the stability and profitability of the firm, together with expected returns attained from such investment will take precedence over other ratios.