Ratio analysis is the simplest way to measure the financial strength and weakness of a company. We cannot calculate financial ratios without financial statements.
Ratio analysis is a valuable tool that enables investors to understand the efficiency of management by looking at financial analysis trends.
What is Financial Ratio Analysis?
Ratio analysis is a quantitative technique of the analysis of a company's financial statements such as balance sheet, income statement and cash flow statement computing different financial ratios.
Ratio analysis measures the profitability, efficiency and liquidity of a company. Hence, it helps the management to make several valuable decisions. Ratio analysis is the key part of fundamental equity analysis.
Understanding of the Financial Ratios
Analysts and investors use the financial ratios or accounting ratios to understand the financial health of a company by verifying past and present financial statements.
The financial statements could indicate how a company is performing over the year and help to understand the potential performance in the future.
The financial statements data can compare the financial position of a company with the industry average and also could compare the others within the relative sector.
Hence, investors could use financial ratio analysis easily and all the data is available on the financial statements of a company. Typically, the financial ratio can be calculated for either quarterly or yearly.
Remember, investors do not only rely on financial ratios because a company can manipulate its financial statements numbers and compute other parameters also. Accounting ratios are not usually used in isolation but are combined with other ratios.
What are the types of Financial Ratios?
The financial ratios can be divided into six categories. Look at the financial ratios are,
1. Profitability Ratios
Profitability ratios measure the profitability of a company. It represents how well a company is generating profit from total capital. The profitability of a company also signals the competitiveness of the management.
A higher profitability ratio than in the past period might indicate that the company is growing financially. Some examples of profitability ratios -
- Return on Equity
Return on equity is a profitability ratio that measures how efficiently a company uses its shareholders' equity capital to generate income.
Return on equity = (Net Income/ Shareholders' Equity)
- Return on Assets
The return on assets measures how efficiently a company uses its overall resources to earn profits during a period.
Return on assets = (Net Income/ Average Total Assets)
- Return on Capital Employed
Return on capital employed evaluates how efficiently the company uses its total capital and tells you the profit generated by each rupee employed.
Return on capital employed = (Earnings Before Interest and Tax / Capital Employed)
- Net Profit Margin
Net profit margin represents the profit per rupee of sales for the firm.
Net profit margin = Net Profit/ Sales
2. Liquidity Ratios
Liquidity ratios measure the ability of a company to pay off short term liabilities using its current assets or quick assets.
Some examples of liquidity ratios include -
- Current Ratio
The current ratio is a liquidity ratio that reflects the current assets or short term assets that are sufficient to repay the current liabilities within one year.
Current ratio = (Current Assets / Current Liabilities)
- Quick Ratio
The quick ratio measures a company's ability to pay its short term liabilities with the most liquid assets.
Quick ratio = (current Assets - inventory - prepaid Expenses) / current Liabilities
- Cash Ratio
The cash ratio is also known as the super quick ratio that measures the cash position of the company to pay off immediate short term obligations.
Cash ratio = (Cash & Cash Equivalents / Current Liabilities)
3. Solvency Ratios
Solvency ratios are called leverage ratios that gauge the ability of a company to pay off its long term liabilities.
A company is said to be insolvent when the total liabilities of a company exceed its total assets. Few examples of solvency ratios are given below -
- Debt to Equity Ratio
The debt to equity ratio is a leverage ratio that evaluates the amount of debt taken by the company per rupee of the shareholder's funds.
Debt to equity ratio = (Total Debt / Shareholders' Equity)
- Debt to Asset Ratio
The debt to asset ratio shows the proportion of assets being held by a company that is funded by debt. It is an indicator of the use of external funds in the company.
Debt to asset ratio = (Total liabilities / Total assets)
4. Activity Ratios
Activity ratios are also called efficiency ratios. It computes how efficiently a company utilizes assets and liabilities to generate sales and improve profit margins.
Some important activity ratios are following -
- Inventory Turnover Ratio
The inventory turnover is an activity ratio and also called a 'stock turnover ratio' that shows the number of times a company has sold and replaced its inventory in a year.
Inventory turnover ratio = (Cost of Goods Sold / Average Inventory)
- Asset Turnover Ratio
The asset turnover ratio is called the total asset turnover ratio that measures how efficiently a company utilizes its assets to generate sales.
Asset turnover ratio = (Net Sales / Average Total Assets)
- Working Capital Turnover
Working capital turnover reflects how efficiently a business is producing sales for every rupee of working capital.
Working capital turnover = (Net sales / average working capital)
- Payable Turnover Ratio
The creditors turnover ratio measures the number of times a company pays off its creditors in a year.
Creditor turnover ratio= (Net credit purchases / Average Trade Payables)
5. Coverage Ratios
Coverage ratios gauge a company's ability to cover its debts and other obligations associated with the costs. Investors and analysts can predict the financial performance of a company in future with help of coverage ratios.
The major coverage ratios are -
- Debt Service Coverage Ratio
The debt service coverage ratio measures how efficiently a company can pay off its current debt service obligations.
Debt service coverage ratio = Net Operating Income / Debt Service Coverage Ratio
- Times Interest Earned Ratio
The time's interest earned ratio gauges the ease with which a company can pay its interest expenses on outstanding debt.
Interest Coverage ratio = (EBIT / Interest Expenses)
6. Market Prospect Ratios
Market prospect ratios enable investors in forecasting how much they will earn from specific investments. The earnings can be a form of higher stock value or future dividends.
Important market prospect ratios are -
- Price to Earnings Ratio
The price to earnings ratio represents the investors are willing to pay for a stock per rupee of income.
P/E ratio = (Market price per share/earnings per share)
- Earnings Per Share
Earnings Per Share is an indicator of the profitability of the company and the earnings per share ratio implies that the percentage of a company's earnings is distributed to each outstanding share of a company.
Earnings per share = ( Net Profit - Preferred Dividends ) / End-of-Period Common Shares Outstanding
- Dividend Payout Ratio
The dividend payout ratio is the total amount of dividends paid to shareholders relative to the net profit of the company.
Dividend payout ratio = (Dividends Paid / Net Profit)
Uses of ratio analysis
1. Comparison
The main uses of ratio analysis are to compare similar ratios to its competitors within the same sectors and compare the financial statements across all of the companies reviewed. It helps to understand the company's financial position in the market.
Obtaining accounting ratios such as the current ratio, from known short term debt position, strength, weakness and current cash position and also known the competitors' financial position from others.
2. Trend line
Financial ratios are used for glimpsing the financial trend of a company. Hence, comparing the performance of a company over some time. The trend obtained can be used to predict a company's future growth and financial performance using ratio analysis.
3. Operational Efficiency
The management of a company also uses financial ratio analysis to consider the degree of efficiency in the management of assets and liabilities. The overutilization and underutilization of assets or financial resources can be tracked with the help of financial ratio analysis.
