Once the financial statements of businesses are prepared, they then need to be analyzed. One such tool to analyze and assess the financial situation of a firm is ratio analysis. Ratio analysis is a quantitative method of studying a company’s financial statements, such as the balance sheet and income statement, to gain insight into its liquidity, operational efficiency, and profitability. The process examines and compares financial information through financial statement figure percentage calculations instead of comparing line items from every financial statement. Just like a lawyer examines his client by knowing all the critical elements of the story before advising clients on all aspects of the law and presenting cases at court proceedings and hearings, a financial analyst analyses the financial statements with various tools of analysis before commenting upon the financial health or weaknesses of an enterprise. This will then allow managers to understand the accounts better understand the current economic scenario.

There are mainly five types of ratio analysis. The profitability ratio is the type of ratio analysis that suggests the returns generated from the business with the capital invested. Solvency ratio analysis indicates whether the company is solvent and can pay off the lender’s debts or not. Liquidity ratios represent whether the company has enough liquidity to meet its short-term obligations or not—higher liquidity ratios are more cash-rich for the company. Turnover ratios signify how efficiently the assets and liabilities of the company are used to generate revenue, and the earnings ratio analysis type speaks about the returns that the company generates for its shareholders or investors.

Interpreting the financial statements and other financial data is essential for all stakeholders of a business. Thus, ratio analysis becomes a vital tool for financial accounting and management that will improve your understanding of financial results and trends over time and provide key indicators of organizational performance. To help form strategies and initiatives, they must be calculated using reliable and accurate financial information that reflects the true cost picture and calculated consistently from time to time.

Benchmarking compares your data against the industry benchmark and develops an action plan to better the company’s health so that your business grows at a better rate than the industry benchmark.