Why are ratios useful?

Answer 1

USEFULNESS OF RATIOS

Readers cannot easily answer questions about a firm's profitability and risk from the raw information in financial statements. For example, one cannot assess the profitability of a firm by noting the amount of net income—large net income could result from a large firm earning small profits on its transactions or from a small firm earning large profits. Comparing net income with the assets used to generate those earnings will provide more useful information. The analyst expresses these (and other useful) relations between items in the financial statements in the form of ratios. Some ratios compare items within the income statement; some use only balance sheet data; others relate items from more than one of the three principal financial statements. Ratios aid financial statement analysis because they conveniently summarize data in a form easy to understand, interpret, and compare.
Ratios provide little information unless the analyst places them in a context. For example, does a rate of return on common shareholders' equity of 8.6% indicate satisfactory performance? After calculating the ratios, the analyst must compare them with some standard. The following list provides several possible standards:

1 . The planned ratio for the period.
2 . The corresponding ratio during the preceding period for the same firm.
3 . The corresponding ratio for a similar firm in the same industry.
4 . The average ratio for other firms in the same industry.