The financial stability and growth of a business are the determining factors for the future prospects of a business, such as whether or not investors will provide funding, expansion plans, etc. This requires assessing the financial health report of the business in a quantitative form which is vital to know about the company in detail. How can you do that?
Ratio analysis is your best bet. Although financial statements also provide a quantitative view of a business, ratio analysis provides a collective inspection of different financial aspects. It also provides a scale to measure a firm’s performance when compared to other businesses in the same sector.Investors and financial experts use it to understand the business’s past conduct as well as can predict its future growth spectrum. Comparative data collected through ratio analysis is helpful in demonstrating the company’s financial standing over time. Before moving on to the nits and grits of types of ratio analysis, let’s just understand the definition in the simplest term.
What is Ratio Analysis?
It is a quantitative method that gives insight into a business’s liquidity, profitability, and operational efficiency. Investors and finance experts analyze all the financial statements of a business to gain insight into its financial standing. Ratio analysis has a normalization aspect through which a business can have comparable data of another business belonging to the same industry or sector, i.e., it provides a measuring scale. In short, the management/owners will get a good idea of where their business actually stands when compared to its competitors within the same sector.
Types of Ratio Analysis
Now you can’t just use one formula and predict every aspect of a business. That is why Financial ratio analysis can be broken down into six types. Ratio analysis formulas are used to calculate the values of each of these ratios. These financial ratios are evaluated in this order:
1. Liquidity Ratios:
The liquidity ratios are used to determine a business’s ability to pay off all its short-term debts using current assets without raising capital from external sources. Investors use three types of liquidity ratios:
- Current ratio = current assets ÷ current liabilities
- Quick ratio = (current assets – inventory) ÷ current liabilities
- Cash ratio = (cash + cash equivalent) ÷ current liabilities
2. Solvency Ratios:
The solvency ratio is used to determine whether a business can pay off its long-term debts along with any interest debt associated with it without needing any external capital. These are also known as financial leverage ratios. These ratios measure a company’s actual cash flow rather than the net income by adding depreciation to analyze a company’s ability to stay in the game. The solvency ratio is calculated as:
Solvency Ratio = [(Net Income + Depreciation) ÷ Liabilities (Short-term and Long-term Liabilities)] ✕ 100.
There are many types of solvency ratios:
- Debt to Equity ratio = long-term debt ÷ shareholder’s funds
- Debt ratio = long-term debt ÷ capital
- Equity ratio = shareholder’s funds ÷ capital
- Interest coverage ratio = earnings before tax and interest ÷ interest on long-term debts
You can know the long-term health of the company by using solvency ratios. Therefore, a higher solvency ratio is sought after by investors.
3. Profitability Ratios:
This ratio analysis evaluates the business’ ability to generate income and keep up with its expenses. In simpler terms, the profitability ratio explains how well your company is doing in terms of profits. Types of profitability ratios:
- Return on equity = net income ÷ shareholder’s equity
- Earnings per share = (net income – preferred dividends) ÷ end-of-period common shares outstanding
- Dividend ratio = annual dividends per share ÷ current share price
- Return on capital employed = earnings before interest and tax ÷ capital employed
- Return on assets = net income ÷ total assets
- Price to earnings ratio = share price ÷ earnings per share
- Gross profit = net sales – cost of goods sold
- Net profit = (revenue – cost) ÷ revenue
Investors prefer a higher profitability ratio because it shows whether the business can generate profit efficiently and provide value for shareholders.
4. Efficiency Ratios:
This is also known as the activity ratio, which is used to determine the current or short-term performance. More precisely, the efficiency ratio measures how efficiently the business uses all its internal assets and liabilities to earn profit. Some types of efficiency ratios are:
- Asset turnover ratio = net sales ÷ average total assets
- Payables turnover = credit purchase ÷ average accounts payable
- Inventory turnover = cost of goods sold ÷ average inventory
- Working capital turnover = net sales ÷ average working capital
- Fixed asset turnover = net sales ÷ average net fixed assets
- Receivables turnover ratio = net sales ÷ average receivables
5. Coverage Ratios:
Coverage ratios analyze how good the business is at completing its financial obligations. It can help in identifying companies that can be in potential financial trouble. There are three types of coverage ratios:
- Interest coverage ratio: earnings (before interest and tax) ÷ interest expense
- Debt coverage ratio: net operating income ÷ total debt service
- Asset coverage ratio: (total assets – short-term liabilities) ÷ total debt
A higher ratio signifies that it is easy for the business to pay off all its financial obligations like its interest payments and dividends. Investors and stakeholders also use coverage ratios to determine if the business is in ‘trouble’.
6. Market Prospect Ratios:
Market prospect ratios evaluate how much capital the potential investors will earn from their investments in the business. Current earnings and dividends are both used to determine the market prospect of the business. This ratio helps investors evaluate what they can expect to receive by investing in the business. There are four market prospect ratios:
- Dividend yield ratio = Dividend ratio = annual dividends per share ÷ current share price
- Price to earnings ratio = Price to earnings ratio = share price ÷ earnings per share
- Earnings per share = Earnings per share = (net income – preferred dividends) ÷ end-of-period common shares outstanding
- Dividend payout ratio = annual dividends per share ÷ earnings per share
While the process of ratio analysis is comprehensive, it gives investors a clear idea of where the business stands and what they can expect from the business in the future. There are several advantages and limitations of ratio analysis.
Advantages of Ratio Analysis
- It is an efficient tool used to analyze the financial state of an organization. It helps in the evaluation of financial statements that depicts the financial growth of a business and provides a true report to owners, investors, creditors, and bankers. It plays an important role in informing about the progress made by the business to the concerned owners and other related parties. The comparative data collected helps to set targets by investors and senior management for improving the ratio.
- Ratio analysis predicts future performance and initiates the planning of prospective business activities with the help of past financial data. It can help to identify trends in various aspects of a business like profit, sales, and cost by computing relevant accounting ratios pertaining to the last few years. For example, examination of sales patterns lets us know the cause of sales decline which can be due to specific regions, products, or customer base.
- Ratio analysis helps in the comparison amongst various businesses belonging to the same industry or sector. This is a great way to figure out any inefficient firm by simply comparing the performance with different firms.
- It makes the entire financial data easy to be understood by managers and investors. The computing of different accounting ratios showcases the entire information of the financial statements in a concise manner.
- With the help of ratio analysis, it becomes easy to get quantitative data on the efficiency and profitability of a business. It helps evaluate the overall liquidity, solvency, and growth potential of a business.
Limitations of Ratio Analysis
- Ratio analysis is dependent on the business’s financial statements, which can contain old, historical information. It doesn’t provide accurate predictions of future conditions since current variables are not considered. For example, inflation occurs from time to time, so real prices are not reflected on the financial statements. This affects the data collected as it is not adjusted according to changing inflation between periods.
- There are no fixed standards for comparing ratios to one another in ratio analysis. Various firms incorporate different items for calculating ratio analysis which leads to deviation in the results. For example, changes in accounting procedures and policies or operational structure in one business can affect the result of ratio analysis when compared with other firms within the same sector.
- Ratio analysis is a purely quantitative analysis that doesn’t take into account real-world applications or situations. For example, businesses order stock in advance when preparing for the rainy or winter seasons.
- Data presented to calculate ratio analysis by the management of a company might be manipulated to show better results and have hidden figures & facts. Also, human error in the collection of data can lead to incorrect ratio analysis. This results in the inaccurate current financial position of a company. For example, the management of the company can inflate the inventory cost or add depreciation to manipulate the results of ratio analysis.
The Bottom Line
Ratio analysis is a financial tool that investors, governing authorities, business owners, and stakeholders often use to evaluate a business’s financial performance. While there are some limitations of ratio analysis, this method is still used because it gives a clear-cut view of the business’s standing and potential. This financial analysis tool is highly useful for both outside analysts and the internal management of a firm since it provides insights that are significant. It is ideal for realizing the strong and weak points of a company.