Ratio Analysis is a Tool for Evaluating Performance

A popular technique of analyzing the performance of a business concern is that of financial ratio analysis. As a tool of financial management, they are of crucial significance. The importance of ratio analysis lies in the fact that it presents fact on a comparative basis and enables drawings of inference regarding the performance of a firm in respect of following aspects.

1. Liquidity Position:

With the help of ratio analysis one can draw conclusions regarding position of a firm. The liquidity position of a firm would be satisfactory if it is able to meet current obligations when they become due. A firm can be said to have the ability to meet its short-term liabilities if it has sufficient liquid funds to pay the interest on its short maturing debt usually within a year as well the principal. This ability is reflected in the liquidity ratios of a firm. The liquidity ratios are particularly useful in credit analysis by banks and other suppliers of short-terms loans. The various measurable ratios under this category are:
a) Current Ratios (2:1)
b) Liquid Ratios (1:3, 3:1)
c) Absolute Cash Ratio (1:1)

2. Long-term Solvency:

Ratio analysis is equally useful for assessing the long-term financial liability of a firm. This aspect of the financial position of a borrower is of concern to the long-term creditors, security analysis and the leverage or capital structure and profitability ratios which focus on earning power and operating efficiency. Ratio analysis reveals the strength and weaknesses of a firm in this respect. The leverage ratios, for instance, will indicate whether a firm has a reasonable proportion of various sources of finance or whether heavily loaded with debt in which case its solvency is exposed to serious strain. Similarly, the various profitability ratios would reveal whether or not the firm is able to offer adequate return to its owners consistent with the risk involved.
The various ratios under this category are:
a. Debt to total funds ratio (67%)
b. Equity to total funds ratio (33%)
c. Debt equity ratio (2:1)
d. Capital gearing ratio
e. Debt-service coverage ratio
f. Interest coverage ratios

3. Operation Efficiency:

Ratio analysis throws light on the degree of efficiency in the management and utilization of its assets. The various activity ratios measure this kind of operational efficiency. In fact, the solvency of a firm is, in the ultimate analysis, depended upon the sales revenues generated by the use of its assets, total as well as its components.
The various ratios under this category are:
a. Fixed assets turnover ratio
b. Debtors turnover ratio
c. Working capital turnover ratio
d. Finished goods or stock turnover ratio
e. Return on assets

4. Over-all-Profitability:

Unlike the outside parties which are interested in one respect of the financial position of a firm, the management is constantly concerned about the overall profitability of the enterprise. That is, they are concerned about the ability of the form to meet its short-term as well as long-term obligations to its creditors, to ensure a reasonable return to its owners and secure optimum utilization of the assets of the firm.
The various ratios under this category are:
a. Return on investment
b. Return on equity
c. Dividend per share
d. Earnings per share
e. Price earnings ratio