Ratio analysis is one of the most useful techniques for the analysis or interpretation of a financial statement.
Ratio analysis is defined as a technique that analyzes a relationship among components that include financial statements belonging to a particular company for a period of time.
In other words, we can say that a ratio is an expression of the quantitative relationship between two numbers. There are a number of ratios that can help in a better understanding of the financial strengths or weaknesses of the firm. The ratio can be calculated from the information given in the financial statement.
The ratio analysis describes the sustainability of a company’s operation and financial performance relating to profitability, liquidity, activity, coverage, and efficiency. Liquidity describes how well a firm can manage its short-term debt. The activity demonstrates the company’s ability to use its assets to generate sales. Coverage shows the level of protection for long-term debt, which has to be considered along with profitability to develop the complete picture of how a business is thriving.
Classification of Ratios in Ratio Analysis
The following chart depicts the functional classification or classification of the basis of the test from which these ratios are calculated:
Functional classification or classification is the basis of the test:
Liquidity ratios are a class of financial metrics used to assess a company’s ability to pay off its short-term debt obligations. By short-term obligations, we mean all dues and outstanding to be settled within the next 12 months.
- Current Ratio : The current ratio shows how easily the company can pay off its debts now without needing further funding. The business should always have enough liquid assets to cover its short-term obligations without borrowing money from outside sources.
- The liquidity ratio measures the liquid assets, which are current assets reduced by stock and prepaid value, to current liabilities.
- Absolute Liquid Ratio or Cash Ratio: The cash ratio is calculated by comparing cash and cash equivalents to current liabilities.
Long-term solvency and leverage ratio
Long-term solvency is the ability of a company to meet its financial obligations over the long term. Long-term solvency is important because it allows a company to continue to operate and grow over the long term. A company with a strong long-term solvency position will be able to weather the ups and downs of the business cycle and continue to invest in its future.
Following are some of the main ratios that fall under the category of long-term solvency ratios.
- Debt/ equity ratio
- Debt to total capital ratio
- Interest coverage Cash flow/ debt
- Capital gearing
In financial analysis, activity ratios are used to measure a company’s efficiency and performance. Activity ratios can be used to assess how well a company is using its assets and resources to generate sales and profits.
- Inventory turnover ratio – A high inventory turnover ratio indicates a company that sells its inventory efficiently. A low inventory turnover ratio may indicate a company that is holding onto too much inventory or is not selling its inventory quickly enough.
- Debtors turnover
- Payable turnover
- Fixed assets turnover ratio
- Capital employees turnover ratio
- Total assets turnover ratio
- Working capital turnover ratio
Profitability ratio – In relation to sales
Profitability is the most important thing to measure in any business. It tells you how good or bad you are doing.
Profitability is defined as the simplicity with which a business generates income. Profitability ratios determine a firm’s previous performance and assist a company in determining the efficiency with which a firm utilizes its funds to make profits or generate returns.
- Gross profit ratio
- Operating profits ratio
- Operating ratio
- Net profit ratio
- Expense ratio
Profitability ratio: In relation to investment
The following ratios are useful to predict whether the investment in the company will be profitable or not.
- Return on Equity: Return on Equity stands for return on equity. It is a profitability ratio that measures how much profit a company generates with the money that shareholders have invested. In other words, it tells you how well a company is using its capital to generate profits.
- Return on investment (ROI) is a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or a ratio.
- Return on Capital Employed (ROCE) – A company’s capital employed is the sum of its long-term and short-term debt, as well as its equity. ROCE is a good way to measure a company’s overall profitability and how efficiently it is using its capital. A high ROCE means that a company is profitable and is using its capital efficiently. A low ROCE means that a company is not as profitable and is not using its capital as efficiently.
- Earnings per Share – The earnings per share (EPS) is a key metric used by investors to determine a company’s profitability. It represents the portion of a company’s net income allocated to each common stock’s outstanding share.
- Price-Earnings (P/E) ratio – The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The P/E ratio can be calculated by dividing a company’s share price by its earnings per share (EPS). For example, if a company’s stock trades at $30 per share and its EPS is $2, then its P/E ratio would be 15 ($30 divided by $2 equals 15).
Ratio analysis can give valuable insights into a company’s financial health. However, it is important to remember that ratios should only be used as a starting point for further analysis. Financial statements need to be considered in conjunction with other information to get a complete picture of a company’s financial position.