Ratio analysis is an important tool for evaluating the financial performance of a business or organization. It is a process of analyzing key financial ratios to determine the financial strength and weaknesses of the business. It is used to assess both the liquidity and profitability of a company.
What is Ratio Analysis and What is the Main Objective?
Ratio analysis is a financial analysis technique used to compare different financial ratios to gain insight into a company’s financial performance and position. It involves analyzing the relationships between different financial ratios to understand both the company’s current financial performance and its future prospects.
The main objective of ratio analysis is to identify areas of strength and weakness in a company’s financial performance. It is also used to compare a company’s performance to its competitors and to assess its financial health. Ratio analysis is a valuable tool for investors, creditors, and other stakeholders who are interested in measuring a company’s financial strength.
Types of Ratio Analysis
Based on the data sets they provide, the various types of financial ratios available can be broadly classified into the six silos listed below:
#1. Liquidity Ratios
Liquidity ratios assess a company’s ability to pay off short-term debts as they come due, using current or quick assets. The current ratio, quick ratio, and working capital ratio are all liquidity ratios.
#2. Solvency Ratios
Solvency ratios, also known as financial leverage ratios, compare a company’s debt levels to its assets, equity, and earnings to assess the likelihood of a company staying afloat in the long run by paying off its long-term debt as well as the interest on its debt. Debt-equity ratios, debt-assets ratios, and interest coverage ratios are all examples of solvency ratios.
#3. Profitability Ratios
These ratios indicate how well a company’s operations can generate profits. Profitability ratios include profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios.
#4. Efficiency Ratios
Efficiency ratios, also known as activity ratios, assess how effectively a company uses its assets and liabilities to generate sales and maximize profits. The following efficiency ratios are important: turnover ratio, inventory turnover, and days’ sales in inventory.
#5. Coverage Ratios
Coverage ratios assess a company’s ability to make interest payments and other debt-related obligations. The debt-service coverage ratio and the times interest earned ratio are two examples.
#6. Market Prospectivity Ratios
In fundamental analysis, these are the most commonly used ratios. Dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio are among them. These metrics are used by investors to forecast earnings and future performance.
For example, if the average P/E ratio of all companies in the S&P 500 index is 20, and the majority of companies have P/Es ranging from 15 to 25, a stock with a P/E ratio of seven is considered undervalued. A P/E ratio of 50, on the other hand, would be considered overvalued. The former may rise in the future, while the latter may fall until each aligns with its intrinsic value.
Ratio Analysis Formulas and How to Calculate the Ratios
Ratio analysis involves calculating a variety of ratios based on a company’s financial statements. The most common ratio formulas include:
- Current ratio = Current Assets / Current Liabilities
- Quick ratio = (Current Assets – Inventory) / Current Liabilities
- Debt-to-equity ratio = Total Liabilities / Total Equity
- Debt-to-assets ratio = Total Liabilities / Total Assets
- Gross margin = (Net Sales – Cost of Goods Sold) / Net Sales
- Operating margin = (Net Income + Interest) / Net Sales
- Return on assets (ROA) = Net Income / Total Assets
- Return on equity (ROE) = Net Income / Total Equity
- Inventory turnover = Cost of Goods Sold / Average Inventory
- Accounts receivable turnover = Net Sales / Average Accounts Receivable
- Times interest earned = (Net Income + Interest Expense) / Interest Expense
Benefits of Ratio Analysis
Ratio analysis is a powerful tool for financial analysis and decision-making. It can be used to assess a company’s financial performance and position, to compare a company’s performance to its competitors, and to identify areas of strength and weakness.
Ratio analysis can also help identify potential problems, such as a company’s inability to pay its debts or its inefficient use of assets. It can also be used to assess a company’s ability to generate profits, measure its financial leverage, and identify trends in its financial performance over time.
Ratio Analysis’s Disadvantages
When comparing the results of businesses across industries, the use of ratio analysis can be misleading. Ratio results in the utility industry, for example, will be very different from those in the software industry, because utilities have a large fixed asset base, whereas software companies invest in very few fixed assets. This means that a utility is more likely to incur debt to pay for fixed assets, whereas a software company may not incur any debt at all.
How to Prepare a Ratio Analysis
Preparing a ratio analysis requires a thorough understanding of the company’s financial statements. The first step is to determine the ratios to be analyzed. This will depend on the type of analysis being conducted and the company’s objectives.
Once the ratios have been identified, the next step is to collect the necessary financial data. This includes the company’s balance sheet, income statement, and cash flow statement. The financial data should be carefully examined to ensure that it is accurate and up-to-date.
Once all of the financial data has been collected, it is time to calculate the ratios. The ratios should be calculated using the appropriate formulas. The results should then be interpreted to gain insight into the company’s financial performance and position.
What are the 5 Methods of Financial Statement Analysis?
Financial statement analysis is the process of analyzing a company’s financial statements in order to gain insight into its financial performance and position. It involves analyzing the company’s balance sheet, income statement, cash flow statement, and other related financial documents.
The five main methods of financial statement analysis are vertical analysis, horizontal analysis, ratio analysis, trend analysis, and Du Pont analysis.
- Vertical analysis is a method of analyzing financial statements by expressing the amounts of the items in the statements as a percentage of a base amount.
- Horizontal analysis is a method of analyzing financial statements by comparing the financial figures from one period to another.
- Ratio analysis is a method of analyzing financial statements by calculating and interpreting financial ratios.
- Trend analysis is a method of analyzing financial statements by examining the trends in the financial statements over time.
- Du Pont analysis is a method of analyzing financial statements by breaking down a company’s return on equity into its component parts.
Ratio Analysis Example
Let’s take a look at an example of ratio analysis.
Suppose a company has the following financial statements:
- Balance sheet: Assets of $10 million and liabilities of $7 million
- Income statement: Net sales of $20 million, cost of goods sold of $14 million, and net income of $2 million
- Cash flow statement: Cash flow from operations of $4 million
Using the above financial data, the following ratios can be calculated:
- Current ratio = $10 million / $7 million = 1.43
- Quick ratio = ($10 million – $14 million) / $7 million = -0.20
- Debt-to-equity ratio = $7 million / $3 million = 2.33
- Debt-to-assets ratio = $7 million / $10 million = 0.70
- Gross margin = ($20 million – $14 million) / $20 million = 0.30
- Operating margin = ($2 million + 0) / $20 million = 0.10
- Return on assets (ROA) = $2 million / $10 million = 0.20
- Return on equity (ROE) = $2 million / $3 million = 0.67
- Inventory turnover = $14 million / $10 million = 1.40
- Accounts receivable turnover = $20 million / $10 million = 2.00
- Times interest earned = ($2 million + 0) / 0 = Infinite
Application of Ratio Analysis
The basic idea behind ratio analysis is to compare multiple figures and arrive at a calculated value. That value may have little to no value on its own. Instead, ratio analysis is frequently used to determine whether a company’s financial health is strong, weak, improving, or deteriorating.
#1. Ratio Analysis Over Time
A company can perform ratio analysis over time to gain a better understanding of its company’s trajectory. Instead of focusing on where the company is now, this type of analysis is more interested in how the company has performed over time, what changes have worked, and what risks still exist in the future. The use of ratio analysis is critical in making long-term decisions and strategic planning.
To perform ratio analysis over time, a company chooses a single financial ratio and calculates it on a regular basis (i.e. calculating its quick ratio every month). Consider seasonality and how temporary changes in account balances may affect month-over-month ratio calculations. The company then examines how the ratio has changed over time (whether it is improving, the rate at which it is changing, and whether the company wanted the ratio to change over time).
#2. Ratio Analysis Across Companies
Consider a company with a gross profit margin of 10%. This financial ratio may excite a company until it learns that every competitor achieves a gross profit margin of 25%. Ratio analysis can help a company understand how its performance compares to that of similar companies.
Consider only analyzing similar companies within the same industry when using ratio analysis to compare different companies. Furthermore, keep in mind how different capital structures and company sizes can affect a company’s ability to be efficient. Consider how companies with different product lines interact (i.e. some technology companies may offer products as well as services, two different product lines with varying impacts to ratio analysis).
Different industries simply have different ratio expectations. A debt-equity ratio that is acceptable for a utility company that can obtain low-cost debt may be considered unsustainable for a technology company that relies heavily on private investor funding.
#3. Ratio Analysis Against Benchmarks
Companies can set internal targets for what their ratio analysis calculations should be. These calculations may aim to maintain current levels or to increase operational growth. For example, if a company’s current ratio is 1.1, and it wants to become more liquid, it may set an internal goal of having a current ratio of 1.2 by the end of the fiscal year.
External parties, such as lenders, frequently use benchmarks. Lending institutions frequently impose financial health requirements. If these benchmarks are not met, the entire loan may be called or a company may be faced with a higher rate of interest to compensate for the risk. A lender’s benchmark is often the debt service coverage ratio, which compares a company’s cash flow to its debt balances.
Conclusion
In conclusion, ratio analysis is an important tool for evaluating the financial performance of a company. It can be used to assess a company’s financial strengths and weaknesses, compare its performance to its competitors and identify potential problems.
Ratio analysis involves calculating a variety of ratios based on a company’s financial statements. These ratios can be used to assess a company’s liquidity, solvency, efficiency, and profitability.
Ratio analysis is a valuable tool for investors, creditors, and other stakeholders who are interested in measuring a company’s financial strength. By understanding the importance of ratio analysis, investors and other stakeholders can gain insight into a company’s financial performance and position.
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