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1. Forecasting and Planning:
The trend in costs, sales, profits and other facts can be known by computing ratios of relevant accounting figures of last few years. This trend analysis with the help of ratios may be useful for forecasting and planning future business activities.
2. Budgeting:
Budget is an estimate of future activities on the basis of past experience. Accounting ratios help to estimate budgeted figures. For example, sales budget may be prepared with the help of analysis of past sales.
3. Measurement of Operating Efficiency:
Ratio analysis indicates the degree of efficiency in the management and utilisation of its assets. Different activity ratios indicate the operational efficiency. In fact, solvency of a firm depends upon the sales revenues generated by utilizing its assets.
4. Communication:
Ratios are effective means of communication and play a vital role in informing the position of and progress made by the business concern to the owners or other parties.
5. Control of Performance and Cost:
Ratios may also be used for control of performances of the different divisions or departments of an undertaking as well as control of costs.
6. Inter-firm Comparison:
Comparison of performance of two or more firms reveals efficient and inefficient firms, thereby enabling the inefficient firms to adopt suitable measures for improving their efficiency. The best way of inter-firm comparison is to compare the relevant ratios of the organisation with the average ratios of the industry.
7. Indication of Liquidity Position:
Ratio analysis helps to assess the liquidity position i.e., short-term debt paying ability of a firm. Liquidity ratios indicate the ability of the firm to pay and help in credit analysis by banks, creditors and other suppliers of short-term loans.
8. Indication of Long-term Solvency Position:
Ratio analysis is also used to assess the long-term debt-paying capacity of a firm. Long-term solvency position of a borrower is a prime concern to the long-term creditors, security analysts and the present and potential owners of a business. It is measured by the leverage/capital structure and profitability ratios which indicate the earning power and operating efficiency. Ratio analysis shows the strength and weakness of a firm in this respect.
9. Indication of Overall Profitability:
The management is always concerned with the overall profitability of the firm. They want to know whether the firm has the ability 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 utilisation of the assets of the firm. This is possible if all the ratios are considered together.
10. Signal of Corporate Sickness:
A company is sick when it fails to generate profit on a continuous basis and suffers a severe liquidity crisis. Proper ratio analysis can give signal of corporate sickness in advance so that timely measures can be taken to prevent the occurrence of such sickness.
11. Aid to Decision-making:
Ratio analysis helps to take decisions like whether to supply goods on credit to a firm, whether bank loans will be made available etc.
12. Simplification of Financial Statements:
Ratio analysis makes it easy to grasp the relationship between various items and helps in understanding the financial statements.
Lellah answered the question on November 8, 2021 at 09:24
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