A financial ratio is calculated by dividing one number from a firm’s financial statements by another. The resulting solution provides a measure or numeric value that can be used to compare companies' financial footing, overall performance, and assess investment opportunities.
The advantages that accounting ratios provide to a business are as follows.
Helps in analyzing financial statements: Financial ratios are valuable tools for analyzing financial statements, offering insight to bankers, creditors, investors, shareholders, and others. They provide essential information about a business's profitability and health, enabling stakeholders to make informed decisions.
Simplification of accounting data: Financial ratios simplify and summarize a plethora of accounting data and make them easy to read and understand.
Helps in performing comparison: With the help of financial ratios, a comparison of profitability and financial secureness can be made between different companies working and competing in the same industry. Similarly, a comparison can also be made between the current year’s and previous year’s figures.
Helps in identifying the firm’s weak spots: The current year's ratios are compared to the previous year's ratios to identify disparities in a company's operation, and strategies or methods to address such inconsistencies are implemented appropriately.