1. What is Ratio analysis?
Ratio analysis can be defined as the process of accessing a company's financial statements for the purpose of evaluating its liquidity, profitability, solvency and efficiency. In other words ratio analysis involves calculation of various financial ratios for evaluating the financial wellbeing of a company. Few ratios which need to be calculated are liquidity ratios, solvency ratios, turnover ratios, profitability ratios and earnings ratios. It is a part of fundamental analysis for finding the value of a firm.
2. Why do we need ratio analysis?
Access liquidity of the Company
Liquidity refers to whether the company can pay its short-term obligations or not. Short term obligations include all the debts which can be paid off within 12 months or the operating cycle of the business such as salaries, sundry creditors, outstanding expenses, tax payable etc. Current ratio and quick ratio are used to measure liquidity of the firm.
Analysis of Financial Statements
Ratios help to interpret the balance sheet and income statements. Each and every stakeholder has different interests in the company like few look for growth in shares, few look for high dividend and other look for high liquidity, so all these ratios help stakeholders to interpret accordingly.
Profitability of the Company
It helps to determine how profitable the company is. Return on Assets and Return on Equity helps to understand the ability of the firm to generate earnings. Such as how much profit does a company earn for every rupee of its assets or how well a company uses its investors’ money. Then ratios like the Gross profit and Net profit margin help to analyze the company’s ability to convert sales into maximum profit.
Identifying various Risk of the company
It helps in calculating the various leverages such as financial leverage and operating leverages which helps in understanding the business risk, that is how sensitive is the profitability of the company with respect to its fixed cost as well as debt outstanding. Also ratios like Leverage ratio, interest coverage ratio help to understand how a firm is dependent on external capital and whether they are capable of repaying the debt using their capital.
Analysis of Operational Efficiency of the company
Ratios help measure a company’s capability to generate income by using the assets it has. Few aspects to measure efficiency are like the time taken to collect cash from debtors or the time period in which inventory is converted into cash. The efficiency can be compared to itself or other companies according to need.
Compare the Performance of the various company
Different ratios can be used to compare strengths and weaknesses of each firm. Ratios can also be compared to the previous ratio and current ratio of the same firm to measure progress of the company.
Planning and Forecasting of the company
These ratios can be used by analysts and managers to forecast future prospects of the company and help in accurate decision making for the company. Accordingly, various stakeholders can decide to invest in the company or not.
3. Why are the advantages and disadvantages of ratio analysis?
Advantages are as follows:
Ratios simplify financial statements of the company into understandable and simple ratios like liquidity ratio, solvency ratio etc.
It helps in taking important decisions related to financing, investment or distribution decisions by summarizing the financial statements of the company and making numbers into comparable form.
Ratios help in estimating Budget for coming years for the company by analyzing previous trends.
It helps identify certain weak areas of the company where the company can improve to increase profitability.
Disadvantages are as follows:
Ratios may not represent the true picture of a company every time as there are chances of manipulation of accounts often which can improve or worsen the ratios.
It ignores the price level changes in accounts due to inflation or any other factors which again may not represent the correct financial position of the company.
Since ratios are based on financial statements which are completely quantitative so they ignore the qualitative factors like social or environmental factors of the company.
Most importantly ratios analysis don’t have a standard way to interpret. Every person can analyze them in their own way. There are no fixed formulas, one can modify according to his or her needs.
4. Types of Ratio Analysis
1. Liquidity Ratios
These ratios help in measuring the ability of a company to meet its current or short term obligations. A high liquidity ratio means that the company has huge cash and cash equivalents.
Types of liquidity ratios are: –
a. Current Ratio: It is used to evaluate the business efficiency of a company to meet its debt obligations in the upcoming twelve months. A high current ratio means that the company is highly capable of repaying its short-term debt obligations. And a low current ratio means that the company is unable to repay its short-term debt obligations. An ideal Current ratio is 2:1
Current Ratio = Current Assets / Current Liabilities
b. Quick Ratio: It is used to measure the capability of a company in paying off its current liabilities immediately so prepaid expenses and inventory are removed from current assets as they take time to convert into cash. An ideal quick ratio is 1:1
Quick Ratio = (Current asset – prepaid expenses - inventory) / Current Liabilities.
2. Profitability Ratios
These ratios help in measuring overall performance and effectiveness of the company. It determines the ability to earn sufficient profits.
Types of profitability ratios are: –
a. Gross Profit Ratios: It is calculated in order to represent the operating profits of a company after making necessary adjustments to the Cost of goods sold (COGS).
Gross Profit Ratio = (Gross Profit / Net Sales) * 100
b. Net Profit Ratio: It is calculated in order to determine the overall profitability of a company after reducing both cash and non-cash expenditures.
Net Profit Ratio = (Net Profit / Net Sales) * 100
c. Operating Profit Ratio: It is used to determine the financial soundness of a company and its financial ability to repay all its short term and long term debt obligations.
Operating Profit Ratio = (Earnings before Interest and Taxes / Net Sales) * 100
d. Return on Capital Employed (ROCE): It is used to determine the profitability of a company with respect to the capital invested by the owners in the business.
ROCE = Earnings before Interest and Taxes / Capital Employed
3. Solvency Ratios
These ratios determine the proportion of debt and equity in the company’s financial assets. And help to evaluate whether a company is capable of paying off its debt obligations or not.
The types of solvency ratios are: –
a. Debt Equity Ratio: It is used to calculate a company’s financial leverage. In other words this ratio determines the degree to which a company has financed its operations through debt versus owner’s fund. An ideal debt-equity ratio is 2:1.
Debt Equity Ratio = Total Debts / Shareholders Fund
b. Interest Coverage Ratio: It is used to determine the efficiency of a company in paying its interest expenses. Basically to calculate how many times the profits earned by a company are capable of paying its interest expenses.
Interest Coverage Ratio = Earnings before Interest and Taxes / Interest Expense
4. Turnover Ratios
These ratios are used to determine a company's efficiency in utilizing the financial assets and liabilities for the purpose of generating revenues.
The types of turnover ratios are: –
a. Fixed Assets Turnover Ratios: It is used to determine the efficiency of a company in using its fixed assets for the purpose of generating revenues.
Fixed Assets Turnover Ratio = Net Sales / Average Fixed Assets
b. Inventory Turnover: It is used to determine how quickly a company can convert its inventory into sales.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories
c. Receivable Turnover Ratio: It is used to determine how quickly a company can collect or realize cash from its account receivables such as sundry debtors.
Receivables Turnover Ratio = Net Credit Sales / Average Receivables
5. Earnings Ratios
These ratios help in determining the returns that a company generates for its various stakeholders.
The types of earnings ratios are: –
a. Profit Earnings Ratio: This ratio indicates the profit earning capacity of the company. It measures the current share price with respect to its per share earnings.
Profit Earnings Ratio = Market Price per Share / Earnings per Share
b. Earnings per Share (EPS): EPS tells the earnings of an equity holder based on each share. In other words it indicates how much money a company makes for each share of its stock. A higher EPS means the company is earning more profits.
EPS = (Net Income – Preferred Dividends) / (Weighted Average of Outstanding Shares)