Ratio analysis is the process of looking at and interpreting data from financial accounts, such as the balance sheet and profit & loss account.
It involves contrasting one number with another. It makes financial statements easier to interpret for users including shareholders, investors, creditors, the government, and analysts. Ratio analysis is a vital decision-making tool for both internal as well as external users.
While external users such as investors, creditors and lenders are interested in financial performance analysis for the safety of their investment, there are also several advantages of ratios to the management.
We will discuss some important ratios that help the management in making appropriate financial and investment decisions on behalf of shareholders.
The Usefulness of Ratios to Management
Shareholders are interested in the enterprise’s profitability. Priority for a stockholder, as an owner of the company, is the value of their stock and the amount of currency they can anticipate receiving from dividends and capital appreciation over time.
Management is accountable for delivering profits to stockholders, which explains why expectations regarding financial statement analysis are aligned. In addition, they must successfully manage the business, including day-to-day operations, evaluating short-term feedback, and comparing trends across competitors.
Ratio analysis is the process of comparing two numerical values. It enables consumers such as shareholders, investors, creditors, the government, and analysts to comprehend financial statements better.
Ratios that help management form an opinion about the financial solvency of a business are called “Solvency Ratios”. Solvency Ratios indicate the financial soundness of a business to continue the operations of its business smoothly, without any impediments and meet its all obligations.
Liquidity Ratios and Turnover Ratios concentrate on evaluating the short-term solvency of the concern that has already been explained. Now under this part, only the long-term solvency ratios are dealt with. Some of the important ratios are given below in order to determine the solvency of the concerned:
- Debt – Equity Ratio
- Proprietary Ratio
- Capital Gearing Ratio
- Debt Service Ratio or Interest Coverage Ratio
1. Debt – Equity Ratio
This ratio is designed to ascertain the firm’s obligations to creditors to funds invested by the owners. It is an indication of all external liabilities to the owner’s recorded claims. Higher leverage ratios tend to indicate a company or stock with higher risk to shareholders.
Management utilizes this ratio to make informed decisions regarding capital structure adjustments, future financing opportunities, and assessing the overall financial stability of the company.
However, it is difficult to compare the debt-equity ratio across industry groups where ideal amounts of debt will vary.
2. Proprietary Ratio
Proprietary Ratio is also termed as Capital Ratio or Net Worth to Total Asset Ratio. It serves as one of the variants of the Debt-Equity Ratio. The term proprietary fund is called Net Worth. This ratio forms the relationship between shareholders’ funds and total assets.
By analyzing the proprietary ratio, management gains valuable insights into the company’s financial stability, solvency, and potential risks.
3. Capital Gearing Ratio
This ratio is also called Capitalization or Leverage Ratio. This is one of the Solvency Ratios. The term capital gearing describes the relationship between fixed interest and fixed dividend-bearing securities and the equity shareholders’ fund. It is therefore a measure of how a company can meet its obligation, which is to make interest payments. The results that indicate a significantly higher return on investment are desired more often than not.
4. Debt Service Ratio or Interest Coverage Ratio
Debt Service Ratio is also termed Interest Coverage Ratio or Fixed Charges Cover Ratio. This ratio denotes the equation between the amount of net profit before the deduction of interest and tax and the fixed interest charges. It is used as a yardstick for the lenders to understand that the business concern will be able to pay its interest periodically.
Organisations must have a substantial amount of profit to cover interest payments in order to mitigate potential, unforeseeable financial difficulties. The capacity of an organisation to meet its interest obligations is a component of its ability to dissolve and is thus a significant factor in the return for investors.