What is Ratio Analysis?
Financial ratio analysis is a financial survey that involves the calculation and interpretation of various ratios derived from the financial statements of a company. Financial ratios provide insights into the relationships between different financial data points and help evaluate a company’s financial performance, efficiency, liquidity, profitability, and solvency.
Ratio analysis enables stakeholders to assess a company’s financial health, compare its performance to industry benchmarks or competitors, and make informed decisions.
Financial Ratios and Businesses
Successful businesses use financial ratios extensively to measure performance across all dimensions. Good financial management is key to this success. Today, there are many fintech solutions on the market to help business owners with easier financial management.
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What Do Financial Ratios Interpret?
Financial ratios serve as a point of comparison for investors. Through it, stakeholders can evaluate the stocks of the company, compare the company’s present value against its historical numbers, etc. Later, they use these data to make strategies on how to make company ratios and stocks more lucrative. Therefore, one can say financial ratios are not used as it is but rather in comparison to other ratios.
What are the Types of Ratio Analysis?
- Liquidity Ratios
Liquidity ratios determine the ability of a firm to meet its short-term obligations and evaluate its liquidity. Examples of liquidity ratios include the current ratio and the quick ratio.
Current ratio = Current Assets / Current Liabilities
Quick Ratio = Liquid Assets / Current Liabilities
- Profitability Ratios
These ratios evaluate a company’s ability to generate profits relative to its sales, assets, or equity. Examples of profitability ratios include the gross profit margin and the return on equity.
Gross Profit Margin = Gross Profit / Revenue
Return on Equity = Net Income / Shareholder’s equity
- Solvency Ratios
Solvency ratios determine the financial stability of a firm over a period and its ability to meet its future financial obligations. Solvency ratios examples include the interest coverage ratio and the debt-to-equity ratio.
Debt-Equity Ratio = Total Debt / Shareholder’s Equity
Interest Coverage Ratio = Earnings Before Interest & Taxes / Interest Expenses
- Turnover Ratios
Turnover ratios determine the overall efficiency of a firm and are assessed by dividing annual income by annual liability. Examples of turnover ratios are fixed asset turnover ratios, inventory turnover ratios, and receivables turnover ratios.
Fixed Asset Turnover Ratio = Net sales / Average Fixed Assets
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory for the Accounting Period
Receivables Turnover Ratio = Net Credit Sales / Average Accounts Receivables
- Efficiency Ratios
These ratios measure a company’s operational efficiency and effectiveness in managing its assets and liabilities. Examples of efficiency ratios include the inventory turnover ratio and the accounts receivable turnover ratio.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivables
- Market Ratios
These ratios provide insights into the market value of a company’s shares and its relationship with its earnings or financial performance. Examples of market ratios include the price-to-earnings ratio and the dividend yield.
Price-to-Earnings Ratio = Stock Price / Earnings Per Share
Dividend Yield = Annual Dividend Per Share / Price Per Share
- Coverage Ratio
The coverage ratio enables a company and its stakeholders to understand its ability to pay interest and other financial liabilities associated with risks. Some of the prominent examples of coverage ratios are the debt-service coverage ratio and the time-interest-earned ratio.
Debt-Service Coverage Ratio = Net Operating Income / Total Debt Service
Time-Interest-Earned Ratio = Earnings Before Interest & Taxes / Total Interest Expenses
What are the Top Applications of Ratio Analysis?
- Financial Performance Evaluation
Financial ratio analysis helps assess a company’s financial performance over time. By comparing ratios to industry benchmarks, historical data, or competitors, stakeholders can evaluate the company’s profitability, efficiency, liquidity, and solvency. It provides insights into the company’s strengths and weaknesses and helps identify areas for improvement.
- Investment Analysis
This approach is used by investors to evaluate the financial health and potential returns of investment opportunities. It assists in assessing the profitability, growth potential, and risk associated with investing in a particular company. Investors can compare the ratios of different companies to make informed investment decisions.
- Creditworthiness Assessment
Creditors, such as banks or suppliers, utilise ratio analysis to evaluate the creditworthiness and repayment capacity of a company. Ratios related to liquidity, solvency, and profitability provide insights into the company’s ability to meet its financial obligations. Creditors use this information to determine whether to extend credit or establish favourable credit terms.
- Management Decision-Making
Financial ratio analysis is valuable for internal management in making informed decisions. It helps in setting financial goals, evaluating performance against targets, and identifying areas requiring attention. Managers can use ratios to assess the impact of different strategies, measure efficiency, and allocate resources effectively.
- Forecasting and Trend Analysis
Ratio analysis assists in forecasting future financial performance based on historical trends and patterns. By analysing ratios over time, stakeholders can identify trends, anticipate potential issues, and make projections for future growth, profitability, and financial health.
- Mergers and Acquisitions
Ratio analysis plays a crucial role in evaluating the financial viability of potential mergers, acquisitions, or partnerships. It helps assess the compatibility of financial metrics, identify synergies, and determine fair value for the transaction.
Different Comparison Bases of Financial Ratio Analysis
- Ratio Analysis Over Time
This comparison involves a business owner understanding how his/her company will perform over time with respect to its competitors. It also helps the entrepreneurs to decipher the nature of future risks involved and what changes can be implemented to curtail the same. This ratio analysis can be performed by choosing a single financial ratio and evaluating that to a fixed cadence.
- Ratio Analysis Across Companies
This financial ratios analysis tactic involves considering the financial performance of the company with its competitors of similar business niches. During this comparison, different metrics are accessed like similar niche-different product lines, capital structures, changes made in technology incorporation, etc.
- Ratio Analysis Against Benchmarks
Due to the ease of financial ratios analysis and its calculations, every company sets internal targets for financial ratios. However, benchmarks are set by external parties like lending institutions to assess the company’s future performance.
Lending firms set a special requirement to understand the financial health of companies which is directly related to loan documents. Companies that will not be able to meet those requirements will be imposed higher interest payments as a penalty.
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FAQs
What is the benefit of ratio analysis?
Ratio analysis helps in analysing the financial statements of a company. It also helps in understanding the company's strengths, efficiency and weaknesses while projecting the upcoming earnings and cash flow of a firm.
Why is conducting ratio analysis important?
Financial ratio analysis allows for the comparison of a company's financial performance to industry peers, competitors, or sector benchmarks. It helps stakeholders understand how a company is positioned relative to others in the industry, identify competitive advantages or disadvantages, and benchmark performance against industry standards.
What are the examples of ratio analysis?
Current ratio, inventory turnover ratio, and gross profit margin ratio are few examples of ratio analysis. These financial ratios help understand the company's future performance and hence people largely use this method to assess the net profit margin. This metric or ratio is important for investors to decipher the profitability of the company concerning its competitors.
What is the difference between the current ratio and the quick ratio?
The current ratio and quick ratio both come under the liquidity ratio. However, one of the primary differences between the current ratio and the quick ratio is that the current ratio considers all the current assets of the company during calculation. Whereas, quick ratio only gets hold of the firm's liquid assets for evaluation.
