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Pros And Cons Of Ratio Analysis in Accounting

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The financial statements affect the decision-making ability of internal and external stakeholders. Techniques like ratio analysis hold considerable significance in simplifying complex financial numbers. It facilitates budgeting, forecasting, and financial planning. Correct and simplified interpretation is necessary to strategize and gain a competitive edge. Therefore, businesses rely on assessment techniques like ratio analysis to add value and efficiency to decision-making. Businesses undertake this activity themselves or hire accounting outsourcing companies for professional assistance. The accounting personnel prepares financial statements like profit and loss, balance sheet, cash flow, etc., that indicate their financial performance, position, and progress.


Although ratio analysis is pretty standard among various industries, it still clarifies several indicators. Companies calculate ratios as numerical expressions showing their relation with each other. Firms use this quantitative method to assess multiple financial enterprise perspectives. With these ratios, firms know about their growth percentage and operational drawbacks. It allows them to take the right action course and future decisions. The five major types of ratios that use items from the income statement, cash flow statement, and balance sheet include:


Liquidity ratios-

These indicate the company's capacity to meet short-term obligations. Examples include the current ratio, quick ratio, and acid test ratio.


Solvency ratios-

It indicates the ability to meet long-term debt obligations and include debt-equity ratio, interest coverage, etc.


Profitability ratios-

As the name suggests, these ratios determine firms' profit-earning capacity. Examples include net profit margin/ ratio, gross profit margin/ ratio, and operating profit margin/ ratio.


Activity/ performance/ efficiency ratios-

With the help of these ratios, firms know how well/ quick their assets turn into cash. These ratios include debtors turnover ratio, inventory turnover, payables turnover, etc.


Market value ratios-

These ratios measure the company's value in the market. Examples include book value, market value, earnings per share, dividend yield, dividend yield payout, etc. 


Although these ratios indicate the growth pattern, they also suffer from specific limitations. Let us know the pros and cons of ratio analysis through accounting outsourcing services:


Merits-

The following points highlight the benefits of undertaking ratio analysis:


Financial planning and forecasting:

Through ratio analysis, businesses can plan their future finances and forecast performance and growth trends. By matching it with previous records, firms get an upward or downward trend to forecast future performance and progress. Long-term business activities get planned accordingly by accounting outsourcing services.


Budgeting:

With knowledge about cash outflow, inflow, where the money gets spent the most or least, and other related indicators, firms can allocate resources to maximize returns and minimize expenses. Past experiences influence current conditions.


Financial and operational efficiency:

Financial ratios indicate the efficiency with which a business operates and spends its finances. It shows how different assets get utilized for growth, productivity, and profitability.


Communication to stakeholders:

Ratios are an excellent way for accounting outsourcing companies to communicate the truth about their financial performance, position, and operations to the internal and external stakeholders.


Comparisons and internal control:

Firms can compare the ratios with external companies, including competitors, to know where they stand. Similarly, they can match them with past years' records to evaluate how much a company has progressed or changed over the years. It strengthens internal control.


Demerits:

The following points reflect the limitations of ratio analysis:


Historical information:

Ratio analysis does not support the forward-thinking approach directly. It is because it consumes and processes historical data for evaluation. It may not yield relevant results.


Lack of comparison standards:

There are no benchmarks to follow for every ratio and depend on industry averages, fluctuations, etc. Thus, it makes comparison challenging. 

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