In this era of technology, finance and accounts play a vital role in every sector to reach the top position by following the financial regulations. So to make sure that your firm is performing well, the company has to keep an eye on numbers. To understand these financial numbers, every firm makes use of ratio analysis to accurately calculate its profitability, company’s financial ranking, performance, and liquidity. This tool supports investors in decoding the primary financial data and converting it into a profitable portfolio.

What is a Ratio?

The ratio is an arithmetic expression that compares two values by correlating them with each other. Account ratios are generally linked to the balance sheet and profit and loss accounts of a company.

Types of Ratios:

There are 5 major types of ratios: Liquidity Ratio, Solvency Ratio, Turnover Ratio, Profitability Ratio, and Market Ratio.

1. Liquidity Ratio: This type of ratio indicates the company’s capability to fulfil its current liabilities or short-term obligations.
2. Solvency Ratio: This type of ratio evaluates the company’s capability to pay non-current liabilities.
3. Turnover Ratio: This type of ratio measures a company’s efficiency in utilizing its assets or capital. It is also called the activity ratio.
4. Profitability Ratio: This type of ratio measures the basic earning power or the profitability of a company.
5. Market Ratio: This type of ratio compares the share price of a company with the net income or profit.

What are Financial ratios or Accounting ratios?

Financial ratio indicates the numeral comparison of two or more than two figures in a company’s financial report. Financial reports like the balance sheet, profit and loss statement (P/L), and cash flow statement. This comparison is used to evaluate the company’s financial performance, condition, and efficiency.

The financial or accounting ratio helps to study the factors like net income, liquidity, debt, and efficiency of a company that support stakeholders, investors, financial managers, and financial analysts in making strategic planning. It also compares the performance of any company over a period of years against its standards.

What is Ratio Analysis?

It is the structured use of ratios obtained from financial statement to evaluate the potential, flaws, and overall financial modeling growth of an organization.

Example:

• The current working capital ratio equates current liquid assets with current liabilities.
• The debt-to-equity ratio highlights the amount of debt funding linked to stockholders’ equity.
• Net profit ratio, often considered as a net margin or the bottom line, is a ratio that stakeholders use to make a comparison between the profitability of two companies working in the same sector. The calculation is done by dividing the company’s total revenue, and it is generally used to compare the profits of two companies.
• If company AB and company XY are working in the same sectors with net margins of 25% and 5%  respectively. Then, the stakeholder comparing the two companies will get to know that company AB converted 25% of its income into profits, whereas XY only converted 5%. 

Explanation:

• Gross Margin = ( Net Profit / Sales ) × 100
• Return on Investment = ( Net Profit /  Total Assets) × 100

Besides, the above formula gives clarity on how effectively funds are being used.

What is Financial Analysis?

Financial analysis is a process of measuring the financial health and financial performance of a company by studying its financial reports like profit reports, balance sheets, and statements of cash flow. The study indicates the net income and solvency of the company. It helps shareholders like investors, lenders, and managers to make strategic decisions by gaining financial foresight.

What is Financial Ratio Analysis?

The financial ratio analysis is a process in which the figures from the financial reports are used to calculate various ratios like liquidity ratio, solvency ratio, and turnover ratio. These ratios are used to calculate the financial performance, financial health, and effectiveness of a company over a period of time.

By analyzing and comparing these ratios, financial analysts, creditors, and investors gain a foresight of the company’s solvency, net income, and operational efficiency to make strategic decisions.

Objectives of Ratio Analysis –

The prime objectives of Financial ratio analysis are:

• Evaluating Financial Performance: It is a calculation of efficiency, profitability, and solidity.
• Comparing Change in Pattern: This comparison ratio helps in determining the growth, fall, or stability over a financial year.
• Helping Decision-Making: A financial manager uses this ratio to make calculated and tactical decisions.
• Rating Against Competitors: This ratio helps in comparing the company standards or competitor performance.
• Calculating Liquidity and Solvency: This ratio helps to find out whether a company can meet its short-term and long-term duties.
• Investment Analysis: This ratio helps stakeholders and money lenders to evaluate risk and profit potential.

Ratio Analysis Formulas –

Firstly to understand how it works, one must know the basic formulas. The following are some important key formulas, which include:

1. Liquidity Ratios

The current position of an organization is evaluated by Liquidity Ratios. The term liquidity means the organization’s capability to fulfil its current liabilities. Hence, the liquidity ratio showcases the organization’s capability to fulfil its current liabilities from current available resources.

It includes: 

• Working Capital Ratio, also known as Current Ratio
  Current Ratio = Current Assets / Current Liabilities

• Quick Ratio, also known as Liquid Ratio
  Quick Ratio = (Current Assets – Inventory) / Current Liabilities

2. Solvency Ratio

The organization’s capability to fulfil its long-term liabilities during the maturity period is calculated by Solvency Ratios. 

It includes:

• Debt to Equity Ratio = Debt / Equity
• Total Assets to Debt Ratio = Total Assets / Debt
• Proprietary Ratio = Proprietary’s Fund / Total Assets
• Interest Coverage Ratio = (Earnings Before Interest and Taxes(EBIT) / Interest Expense)

3. Turnover Ratios

Turnover Ratio shows how effectively the working capital and inventory are used to generate total money an organization gains from its operations. It shows how many times the capital used has been  revolved in performing the business operations.

It includes:

• Inventory Turnover Ratio is also known as stock Turnover Ratio
  Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory

• Debtors Ratios is also known as Receivables Turnover Ratio
  Debtors Ratios = Net Credit Sales / Average Receivables

• Creditors Ratio is also known as Payable Turnover Ratio
  Creditors Ratio = Net Credit Sales / Average Payable

• Working Capital Turnover Ratio
  Working Capital Turnover Ratio = Net Revenue from Operations / Working Capital

4. Profitability Ratios

The performance of an organization is calculated by the profit it gains. Profitability Ratio calculator calculates various elements of the profitability of an organization.

It includes: 

• Overall Profitability Ratios
• General Profit Gain Ratio

The following are some general profitability ratios:

• Gross Profit Ratio
  Gross Profit Ratio = (Cost of Goods Sold – Net Sales) / Net Sales

• Operating Ratio
  Operating Ratio = ((Cost of Goods Sold + Operating Expense) / Net Sales) × 100

• Operating Profit Ratio
  Operating Profit Ratio = (Operating Profit / Net Sales) × 100

• Net Profit Ratio
  Net Profit Ratio (Before Tax) =( Net Profit / Net Sales) × 100
  Net Profit Ratio (After Tax) = (Net Profit / Net Sales) × 100

• Return on Investment Ratio is also called Return on Capital Engaged
  Return on Investment Ratio = (Net Profit Before Interest and Tax / Funds Employed) × 100

Types of Ratio Analysis –

The financial ratio analysis is broadly classified into six major types, depending upon the nature of information it uses and what it signifies. With the help of these ratios, each group gives a complete overview of organization from various perspectives that help to find out the potential indicators.

1. Liquidity Ratios

Liquidity ratio calculates an organization’s capability to repay its current debt by using the organization’s present or quick assets.

It includes:

• Current Ratio
• Quick Ratio or Acid Test
• Working Capital Ratio or Current Ratio

2. Solvency Ratios

Solvency ratio, also known as leverage ratio, compares an organization’s financial obligations with its assets, capital, and profits. It is also used to measure financial risk by staying solvent over the long-term investment by repaying long-term liabilities and the interest on those liabilities.

It includes:

• Debt-Equity Ratios 
• Debt-Asset Ratios 
• Interest Coverage Ratios

3. Profitability Ratios 

Profitability Ratio is a type of financial ratio through which an organization can find the extent to which it can generate earnings from operations. 

It covers: 

• Profit Margin Ratio 
• Return on Assets
• Return on Equity (ROE)
• Return on Capital Employed 
• Gross Margin Ratio

4. Turnover Ratio 

Turnover ratio, also known as activity ratio or efficiency ratios is a type of financial ratio analysis used to find how effectively an organization uses its assets and liabilities to generate revenue.

This turnover ratio includes:

• Inventory Turnover Ratio  
• Debtors Turnover Ratio

5. Coverage Ratios 

Coverage ratios calculate an organization’s capability that how easily it can pay its interest and other debt obligations. 

It includes:

• Interest Coverage Ratio(ICR) 
• Debt Coverage Ratio (DCR)

6. Market Prospect Ratios 

Market prospects ratios are also called market value ratios, and they are mostly used by stakeholders, shareholders, and investors to forecast profit and future business performance.

It includes:

• Dividend Price Ratio 
• Earning per Share (EPS) 
• Price-to-Earnings Ratio (P/E)

Advantages of Ratio Analysis –

The benefits of financial ratio analysis are ideal for tracking business performance easily and quickly, comparing the competitors’ performance, and plotting market trends over the years. Mostly used by businesses, shareholders, and financial analysts.

1. Strategic Planning: By analyzing the market trend it helps in forecasting and planning.
2. Support in Decision Making: It gives an accurate idea to financial analysts and investors.
3. Calculation: By studying the market flow chart, a financial analyst can calculate the company’s budget.
4. Informative: It provides users with accurate accounting data and major information about the company’s performance.
5. Financial Competency: It helps in measuring the company’s liquid assets in addition to its long-term financial competency.
6. Comparison: It helps to compare the companies’ performance on different scales.
7. Market Analysis: The financial analysis helps to identify financial trends over a period.
8. Simplifies Complex Data: It simplifies raw financial data into easily understandable ratios.
9. Increase Efficiency: It showcases the pros and cons of any business organization and hence increases efficiency.

Limitations of Ratio Analysis –

Financial data analysts must also be aware of the flaws in financial ratio analysis, along with its various benefits.

1. Historical Path Dependence: The Data used to analyze is based on past figures of an organization. Hence, the metrics shown are not necessary to represent the future company performance.
2. Effect on Accounting Policies: if the organization changes its accounting policies or methods, the financial reports may be affected
3. Purchasing Power Risk: Financial reports are released on a timely basis, henceforth a time gap exists between each publication. If there has been any financial fluctuation between years, the accurate financial reports are not shown in the financial records.
4. Financial Operations Transformation: Basically when an organization’s operational structure changes from top to bottom line. Then this large operational change may cause inadequacy in financial statements on the organization’s performance and various other reports.
5. Benchmark Inadequacy: Sometimes, there is variation between the industrial sectors that makes the comparisons tough.

Future of Ratio Analysis –

Standard financial ratio analysis measuring methods are still useful, but with the innovation of artificial intelligence and predictive algorithms, it has become better. Presently, companies are using various data tools instead of using outdated numbers to find the ratios in real time. It provides them with the performance dashboards, which help to make accurate strategic decisions quickly.

Conclusion –

Ratio analysis is an important tool in financial governance. It assists investors in interpreting accounts, evaluating solvency, and making decisions. Even if it has limitations, there are some benefits that make it very essential for organizations, stakeholders, and financial analysts. Hence, with knowledge of the types of ratios, formulas, objectives, and benefits, an individual can manage financial statements more efficiently. The significance of these techniques cannot be exaggerated, whether it is financial ratio analysis or company comparison. Whether stakeholder, manager, money lender, or a commerce student, whichever may be your profession, having a good command of it makes it easy to calculate the efficiency and plan strategically. Hence, it is the keystone of modern financial analysis.

Frequently Asked Questions (FAQs) –

1.What is the process of ratio calculation?

Process of ratio calculation compares two quantity. Firstly, write the two numerical values in fraction form as (Numerator/ Denominator). Then simplify or solve the fraction to its lowest form.

Steps to follow:

• Take the two values or amounts you want to compare.
• Write the two numerical values in fraction form just one above the other. In numerator and denominator form.
• Simplify the fraction to its lowest form. Dividing the numerator and denominator by their greatest common factor (GCF).
• Write down the lowest form of the ratio by placing the colon between them.
• Your final answer should be in (a:b)

Example:

To find out the ratio of two values like 70 and 36.

• Values: 70 and 36.
• Fraction: 70/36.
• Simplify: the greatest common factor of 70 and 36 is 2
• 70/2=35
• 36/2=18

Hence, the simplified fraction is 35/18.

2.Why do we study ratio analysis?

The study of it helps to understand various financial factors, such as return, liquidity, and effectiveness from the financial statements of a company. However, It helps financial analysts in figuring out the market trend and then prepares a strategic plan accordingly.

3.What is a good current ratio? 

The term good current ratio indicates the financial ratio where a company can fulfil its current liabilities or current debts. 

The numerical current ratio between the range of 1.5 and 2.0 indicates that a company has adequate assets to fulfil its current liabilities. Following, this numerical range varies substantially by industry. 

A current ratio of more than 1.0 indicates that a company can still fulfil its current liabilities or current debt, but a value below 1.0 shows liquidity crises.

4.What is a practical example of financial ratio analysis?

It is a procedure of determining the connections among the financial figures on the financial statement of a company to know the financial performance and effectiveness.

Practical Example of Financial Ratio Analysis:

Examine the inventory turnover ratio, which indicates how fastly the company can turn its inventory into sales. Here the company studies its inventory turnover over a period of time to find out how quickly it converted its goods into cash each month. It gives a chance to find the reason why they are lagging or exceeding the target.

5.What is a good equity ratio?

A good equity ratio informs the company about its stability and flexibility, keeping aside its growth, finance, and investment. Correspondingly, it indicates the company’s dependency more on net assets and less on debt for its financial requirements. Hence, it appeals to the lenders as equity gives protection against insolvency.

6. What is a bad equity ratio?

When a company relies heavily on debt to fund its operations and capital, it increases its financial risk, resulting in a poor equity ratio. An equity ratio closer to 5, 6, or 7 signals a higher level of debt. In this scenario, the bank closely scrutinizes that company.

7. What is a good quick ratio?

When a company has an equivalent ratio of 1:1, indicating it has the same quantity of current assets in comparison to short-term obligations, it demonstrates a good quick ratio.In this case, the company can pay off short-term obligations easily.A good quick ratio exceeds 1 or 1:1.