Ratio analysis is the method or process by which the relationship of items or groups of items in the financial statements are computed, determined and presented. Ratio analysis is an attempt to derive quantitative measures or guides concerning the financial health and profitability of the business enterprise. Ratio analysis can be used both in trend and static analysis. There are several ratios at the disposal of the analyst but the group of ratios he would prefer depends on the purpose and the objectives of the analysis.

Accounting ratios are effective tools of analysis. They are indicators of managerial and overall operational efficiency. Ratios, when properly used are capable of providing useful information. Ratio analysis is defined as the systematic use of ratios to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined the term ratio refers to the numerical or quantitative relationship between items/ variables. This relationship can be expressed as:

1)   Fraction

2)   Percentages

3)   Proportion of numbers

These alternative methods of expressing items which are related to each other are, for purposes of financial analysis, referred to as ratio analysis. It should be noted that computing the ratio does not add any information in the figures of profit or sales. What the ratios do is that they reveal the relationship in a more meaningful way so as to enable us to draw conclusions from them.

Advantages of Ratio Analysis

• Ratios simplify and summarize numerous accounting data in a systematic manner so that the simplified data can be used effectively for analytical studies.

• Ratios avoid distortions that may result the study of absolute data or figures.

• Ratios analyze the financial health, operating efficiency and future prospects by inter-relating the various financial data found in the financial statement.

• Ratios are invaluable guides to management. They assist the management to discharge their functions of planning, forecasting, etc. efficiently.

• Ratios study the past and relate the findings to the present. Thus useful inferences are drawn which are used to project the future.

• Ratios are increasingly used in trend analysis.

• Ratios being measures of efficiency can be used to control efficiency and profitability of a business entity.

• Ratio analysis makes inter-firm comparisons possible. i.e. evaluation of interdepartmental performances.

• Ratios are yard stick increasingly used by bankers  and financial institutions in evaluating the credit standing of their borrowers and customers.