It is necessary to do an analysis of the company’s financial statements after they have been prepared. Ratio Analysis is a useful tool for assessing and analyzing a company’s financial health.

Stakeholders can gain a deeper understanding of the financial position and performance of an organization by employing ratio analysis.

6-Key-Objectives-of-Ratio-Analysis-300x300 6 Key Objectives of Ratio Analysis

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Quick Recap

Ratios are a useful mathematical tool for illustrating the relationship between two numbers. Ratio Analysis is used to analyze and evaluate financial statements.


Let’s get deep into ratio analysis.


  1. Determine the Profitability of a Business

Establishing a return on investment is a common goal of ratio analysis. A company’s profitability can be determined using a wide variety of ratios. Return on equity, return on assets, and net profit margin are all examples of such ratios.

Stakeholders in particular populations may be interested in a business’s financial standing for various reasons. There is little doubt that the company’s long-term prospects is of interest to current and potential investors. While it provides insight into the company’s future success, it is also of importance to employees and creditors.

Making money is the end game for any business. If I were to tell you that ABC Company generated $5 million in profit last year, how would you determine if that is a good or bad number? A company’s profitability can be measured with the help of profitability ratios. Management can utilize these ratios to zero in on areas that need attention.


  1. Analysis of Operational Effectiveness

A company’s resource and asset management efficiency can be measured with the help of several ratios. Avoiding pointless costs necessitates making effective use of resources and assets.

Turnover and efficiency ratios can be used as indicators of asset mismanagement.

Allocating and making optimum use of financial and asset resources is critical for keeping costs down. Mismanagement of assets can be uncovered using indicators like the Turnover Ratio and the Efficiency Ratio.

Efficiency ratios are distinct from profitability ratios since they focus on how a company operates rather than how much revenue it generates in profit.


  1. Liquidity

Having sufficient cash on hand to pay off immediate debts like accounts payable is what we mean when we talk about a corporation having sufficient liquidity. One of ratio analysis’s goals is to evaluate how liquid a business is.

A corporation must always be prepared to quickly liquidate assets in order to meet any cash shortfall. A company’s liquidity can be calculated using the quick and current ratios. Keeping these ratios optimal guarantees that the company has sufficient liquidity.


  1. Financial Stability

One more thing we can do with ratio analysis is to figure out how stable a business’s financial situation is. They can be used to evaluate the sustainability of a business. They are able to determine whether or not a company is over-leveraged and whether or not its assets are being over-utilized. Management needs to take urgent action to fix the problem and prevent liquidation. Ratios such as Debt-to-Equity and Leverage are common examples.

Debt financing and outright borrowing have become standard tools of the modern business owner. Lenders would rather give money, especially over longer periods of time, to companies that they believe will be able to repay their debts.

When deciding whether or not to grant a loan, a bank would likely consider the applicant company’s Interest Cover, which indicates the percentage by which the company’s net profit exceeds its interest payments. This number represents their maximum feasible level of debt. One of ratio analysis’s goals is to evaluate a company’s financial stability. Employees, investors, creditors, and rival businesses may also care about solvency.


  1. Comparison Analyses

The ratios need to be compared to industry norms to get a clearer view of the company’s financial health and fiscal status. The corporation can take corrective action if it does not fulfil market criteria.

You may use the ratios to measure the company’s growth by comparing them to the same metrics from previous years. Analysis of trends is the proper name for this.

When evaluating a company’s financial health and economic outlook, it is helpful to compare it to the norms in its industry. If the company’s performance falls short of market expectations, management can make adjustments. You may also evaluate the company’s growth by comparing the ratios to those from prior years. The process is called trend analysis.


  1. Forecasting

Finally, we might consider ratio analysis with the aim of predicting in mind. The future of a company is something that many different user groups would like to try to predict. The potential for organic expansion is one factor that could spark an investor’s interest in a business.

Since retained earnings are an asset, the Internal Rate Of growth would be used to determine the efficacy with which the business is putting its profit to use. By doing so, the analyst or user can gauge whether or not the company can sustain its growth using financing from within.

In terms of making long-term plans, businesses can benefit greatly from using predictions. Such a ratio’s trend might be studied for insight into what the future holds.


Final Thoughts 

When trying to determine the significance of the interrelationships between the numbers on a company’s financial statements, ratio analysis is an invaluable tool. One of the primary goals of ratio analysis is to give useful information about the company’s profitability, solvency, and liquidity.


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