Q7Managerial Economics & Financial Accounting
Question
Explain the concept of ratio analysis.
Answer
Ratio analysis uses mathematical relationships between financial statement figures to evaluate a company's liquidity, solvency, profitability, and efficiency.
Ratio Analysis is a powerful quantitative technique used by management, investors, and creditors to evaluate the financial performance and health of a business. It involves taking two specific numbers from the financial statements (Balance Sheet or P&L) and expressing their mathematical relationship as a ratio, percentage, or times.
Why it is used: Raw numbers (e.g., "We have $1 million in debt") are meaningless without context. Ratios provide context (e.g., "Debt is 10% of total equity").
Main Categories of Ratios: 1. Liquidity Ratios (e.g., Current Ratio): Assess ability to pay short-term debts. 2. Solvency / Leverage Ratios (e.g., Debt-to-Equity): Assess long-term survival and debt burden. 3. Profitability Ratios (e.g., Net Profit Margin, ROE): Assess ability to generate earnings relative to sales or equity. 4. Activity / Efficiency Ratios (e.g., Inventory Turnover): Assess how well the firm utilizes its assets.