Question

Discuss the importance of ratio analysis and describe the type of information that
profitability and liquidity ratios provide the small business owner. ?

Answer 1

Ratio analysis is important because :

• It enables a historical trend analysis of the firm's financial statement (horizontal analysis)
• A comparison of each item in the financial statements in proportion to total assets or total sales (vertical analysis)
• A comparison of the firm's financial statements with other firms (peer-to-peer) analysis
• A quick snapshot of the firm's financial health can be obtained

Profitability ratios provide an overview of the profitability of the firm in relation to various parameters such as sales, equity, total assets, capital employed etc. They can help indicate whether the profits are adequate to justify the investment made in the firm.

Liquidity ratios provide an overview of the short-term liquidity (solvency) position of the firm. They give information about the working capital position, the realizability of short-term assets, and whether short-term liabilities are too high or low. They can indicate whether cash and working capital are being managed efficiently, or whether they are too high, causing a drag on the profitability.