Ratio analysis is used in accounting, finance, and marketing to make informed decisions and forecasts. It breaks down data into ratios to compare and track success, but there are limitations to using ratios. Standard ratios are used for specific tasks, but analysts must understand their importance to avoid false assumptions. Precautions should be taken before using ratios to make decisions.
Ratio analysis is used in accounting, finance, and marketing departments to make more informed decisions and reasonable forecasts. Uses for ratio analysis range from creating common size accounting statements to determining a company’s inventory turnover to tracking the success of a marketing campaign over time. Standard ratios are used for different departments to perform specific tasks. While the use of ratio analysis is important to a business when making decisions, there are also limitations to using such ratios.
Uses of ratio analysis include breaking down data so that it can be compared. When comparing two sets of data, ratios can help bring numbers to equivalent figures. For example, if the company wants to compare the monthly cost of goods sold over the past year, it should not look at the raw numbers. Instead, the company must calculate the cost of goods sold as a percentage of total sales to determine whether costs have actually increased or decreased.
Making forecasts is another use of ratio analysis. Comparing ratios over time can help a company make reasonable predictions about what it should expect in the future if conditions remain the same or similar. Breaking down data into ratios and comparing the ratios over time can also help companies see if trends or cycles are emerging.
Standard relationships have been developed to accomplish certain types of analysis within different business areas. For example, in finance it is common to use earnings per share, gross profit margin, return on assets, and inventory turnover ratios. This not only helps a company compare historical data between itself and its competitors, but employees are usually trained to use these specific ratios before they are hired. Although most ratios are easy to calculate, the analyst must understand the importance of each ratio to avoid making false assumptions.
The dangers of using ratio analysis include not understanding the assumptions made in your calculation, taking price changes into account, or using data that may be incorrect. The uses of ratio analysis are important for analyzing business data, but they can lead to incorrect or misleading calculations. Limitations on the uses of ratio analysis should not prevent companies from using it, but should cause companies to take more precautions before using it to make decisions. For example, if the business has changed its prices and you are comparing profit ratios during this time period, you should be aware that the price change may have had an effect on the number of sales.
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