Ratios can be used in the following ways: –
1. To evaluate the ability of a firm to meet short-term maturing financial obligations as and when they fall due (liquidity ratios).
2. Ratios indicate the ability of a firm to generate returns/ from sales & investments (profitability ratios).
3. Ratios of a given year are compared with similar ratios of past years to determine the performance of a firm over time. This is called trend/time series analysis.
4. Ratios can be compared with those of competitors to determine whether the firm outperformed competitors. This is called cross-sectional analysis.
5. Efficiency ratios indicate the efficiency with which the firm is utilizing its assets or resources at its disposal to generate sales revenue.
6. Ratios of a given year of a firm can be compared with the average industrial performance or norm. This is called industrial analysis.
7. Ratios indicate the extent with which the firm has financed its assets with externally borrowed fixed return capital (gearing ratios).
8. Prediction of bankruptcy. A combination of selected ratios can be used to predict the possibility of insolvency of a firm. The combined figure of these ratios is called Z- score which was developed by Altman.
