What Is the Role of Ratio Analysis in Accounting?

Carrieanne Larmore

The role of ratio analysis in accounting is to provide businesses with a way to understand its financial position, find weaknesses and opportunities, and make reasonable forecasts. Comparing numbers side-by-side does not always provide businesses with a way of determining if their financial position has become better or worse. Instead, ratio analysis in accounting allows businesses to place data in manageable terms in order to better understand their position. This also allows businesses to break data down so that they can recognize any weaknesses or opportunities. While most ratio analysis in accounting is used to determine the business’s current position, some ratios can be used to make financial predictions.

Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

Ratio analysis in accounting involves using historical data in order to understand the business’s past and current financial position. Data is often retrieved from previous financial statements, such as the income statement, balance sheet and statement of cash flows. It can also be collected from competitors in order to do a competitor ratio analysis in accounting. These ratios can be used to determine if the business is holding on to too much inventory, has taken on too much debt, or is not using its cash effectively.

Weaknesses and opportunities can be found by conducting a ratio analysis in accounting. The business may find that it is purchasing more inventory than is needed, which is preventing it from using cash to finance the development of a new product. It could also determine that it is missing out on investment opportunities by keeping too much cash on hand. The use of ratio analysis in accounting is commonly asked for by decision makers on a monthly basis so that they can tract trends and notice weaknesses or opportunities immediately.

Forecasts can be made by using ratio analysis in accounting. When conditions remain the same, or similar, reasonable predictions can be made about the future. For instance, businesses create a common sized income statement to show all of the amounts on the income statement as a percentage of sales. It can then compare these statements historically to determine any trends. Once a trend has been established, it can predict what will happen. So if the selling expenses are increasing consistently by 1% each year, a business can reasonably assume that it will increase by this same rate in the upcoming year if no major changes have been made to reduce its expenses.

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