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Introduction to Ratio Analysis

  • Utsav Mishra
  • Feb 09, 2022
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Every day a company deals with huge numbers of accounting data or financial transactions. 

 

When compared, the financial statements of an enterprise give us an insight into how well the organization is being run financially, or at what position it stands. This evaluation is called financial ratio analysis and is necessary from time to time to make comparisons between different companies or industries. 

 

The figures on an accounting record - the income statement, the balance sheet, and also the cash flow statement - all of these are used to undertake quantitative study and evaluate a company's liquidity, margins,  leverage, growth, rates of return, profitability, and worth, among other things.

 

This blog will focus on some of these major aspects of financial ratio analysis and their importance. So, as we dive in let us try to understand what ratio analysis is.


 

What is Ratio Analysis?

 

One of the earliest methods of financial statement analysis is ratio analysis. It was created by banks and other lenders to assist them in deciding between rival enterprises requesting financing. It can be difficult to compare two sets of financial statements. 

 

The effects of time, being in various industries, and having different ways of doing business can make it nearly hard to determine whether the company is a better investment. Creditors can use ratio analysis to help them overcome these problems.

 

As defined by Investopedia, analysts use current and historical financial statements to evaluate a company's financial performance. They utilise the data to see if a company's financial health is improving or deteriorating, as well as to make comparisons to other companies.

 

Ratio analysis is rarely used by corporate insiders since they already have access to far more detailed information that gives them a better picture of the company's financial situation. 

 

Also Read | What is Investment Analysis?

 

Types of Ratio Analysis

 

  1. Liquidity Ratio

 

The ability of a corporation to satisfy its debt obligations with current assets is measured by liquidity ratios. When a business is having financial difficulties and is unable to pay its bills, it can convert its assets into cash and utilise the funds to pay off any outstanding debts.

 

The quick ratio, cash ratio, and current ratio are all typical liquidity ratios. Banks, creditors, and suppliers use liquidity ratios to assess a client's capacity to meet their financial obligations when they become due.

 

  1. Solvency Ratio

 

Solvency ratios are used to assess a business's long-term financial stability. These figures compare a company's debt to its assets, equity, or yearly earnings.

 

The debt to capital ratio, debt ratio, interest coverage ratio, and equity multiplier are all important solvency ratios. Governments, banks, employees, and institutional investors are the most common users of solvency ratios.

 

  1. Profitability Ratio

 

Profitability ratios assess a company's ability to make money in relation to its expenses. A higher profitability ratio than in the preceding financial reporting period indicates that the company's financial situation is improving. A profitability ratio can also be compared to that of a similar firm to see how profitable a company is in comparison to its competitors.

 

The return on equity ratio, return on assets, profit margin, gross margin, and return on capital employed are all examples of essential profitability ratios.

 

To learn more about profitability resources, watch this:


 


  1. Efficiency ratios

 

Efficiency ratios assess how effectively a company uses its assets and liabilities to create revenue and profit. They figure out how much inventory is being used, how much machinery is being used, how much liability is being turned over, and how much equity is being used. These ratios are crucial because if the efficiency ratios improve, the business will be able to create more revenue and profits.

 

The asset turnover ratio, inventory turnover, payables turnover, working capital turnover, fixed asset turnover, and receivables turnover ratio are all key efficiency ratios.

 

  1. Market prospect ratios

 

Market prospect ratios assist investors in estimating how much money they will make from a certain investment. Earnings can come in the form of increased stock value or future dividend payments. Current earnings and dividends can be used by investors to forecast future stock prices and dividends.

 

Dividend yield, earnings per share, the price-to-earnings ratio, and the dividend payout ratio are all-important market prospect ratios.

 

  1. Coverage ratios

 

Coverage ratios are used to assess a company's capacity to meet its debt and other obligations. Analysts can use the coverage ratios to create a trend that anticipates the company's financial status in the future over numerous reporting periods. A higher coverage ratio indicates that a company can more easily service its debts and associated responsibilities.

 

The debt coverage ratio, interest coverage, fixed charge coverage, and EBIDTA coverage are all important coverage ratios. (Reference)

 

Also Read | Definition of Insider Trading

 

For What We Use Ratio Analysis?

 

Ratio analysis compares a company's financial situation to that of other companies or to its own past financial performance. Because the results of ratio analysis are static data, they must be compared to other data to be relevant. 

 

Ratio analysis can be used to calculate business trends and to compare one company to others in its industry, among other things.

 

  1. Trends in business

 

Trends can be used to identify the direction of a financial component of a firm, such as whether profitability is increasing or decreasing, whether the company is paying off or accruing debt, and how well the company is managing its assets under the new CEO compared to the previous one.

 

Calculating these ratios over a number of reporting periods can help you spot trends. You can better forecast the future course of the business by comparing current ratios to those from the past.

 

  1. Comparison of competitors

 

Comparing a company against others in the same industry is another technique to apply ratio analysis. Businesses in the same industry will have capital structures and fixed assets that are similar. You can tell whether a company is an industry leader or just keeping up with competitors by comparing the findings of their ratio analysis. (Source)

 

 

Advantages of Ratio Analysis

 

The following are the most common advantages of ratio analysis:

 

  • Ratio analysis is a method of directing a company's operational decisions based on a percentage number. As a result, depending on the value that ratio analysis has signified, firms can either encourage or discourage a managerial policy. 

 

Furthermore, ratio analysis converts financial statement statistics into simplified ratios and percentages. As a result, businesses can make quick decisions to improve their financial situation.

 

  • Ratio analysis is a decision-making tool that actively considers the advantages and disadvantages of operations. Because ratio analysis also displays an organization's growth component, it brings various operational areas under management's scrutiny. 

 

As a result, the decision-making bodies inside a corporation can precisely evaluate the organization's disadvantages.

 

  • Ratio analysis can also reveal information about a company's success in its industry. Furthermore, this procedure aids a corporation in determining its place in the related industry. As a result, organisations use the ratio analysis method to uncover strategies to outperform their market competition.

 

Also Read | What is Fiat Money and how is it printed?


 

Conclusion

 

The use of ratio analysis can be misleading when comparing the results of businesses across industries. 

 

For example, ratio results in the utility industry will be completely different from those in the software industry, because utilities have a large fixed asset base, while software companies invest in few fixed assets at all. This means that a utility is more likely to incur debt in order to pay for its fixed assets, while a software company may incur no debt at all.

 

But, keeping the rare disadvantages aside, we can say that ratio analysis is a really beneficial tool for any business. It lets the business know about its financial evaluations and predictions just by looking at the current and past company statements.

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