What is Ratio Analysis?
Ratio analysis refers to the comparisons between different pieces of financial information in the financial statements of a business. They are mainly used by external analysts to determine various aspects of a business such as its profitability, liquidity, and solvency.
Analysts rely on the current and past financial statements to obtain the correct data to evaluate the financial performance of a company. They also use the data to determine if a company’s financial health is on an upward or downward trend and draw a comparison against other competing firms.
Uses of Ratio Analysis
One of the uses of ratio analysis is to compare the company’s financial performance to similar firms in the industry to understand the company’s position in the market. Obtaining data from known competitors and comparing it to the company’s ratios can help the management identify market gaps and elaborate on its competitive advantages, strengths, and weaknesses. The management can then use the information to formulate decisions that improve the company’s position in the market.
2. Trend line
Companies can also use ratios to see if there is a trend in financial performance. Established companies collect data from the financial statements over a large number of reporting periods. The trend obtained can be used to predict the direction of future financial performance, and also identify any expected financial turbulence that would not be possible to predict using ratios for a single reporting period.
3. Operational efficiency
The management of a company can also use financial analysis to determine the degree of efficiency in the management of assets and liabilities. At any time, the management expects the assets to be put to optimal use, but that does not happen all the time. Inefficient use of assets such as motor vehicles, land, and building results in unnecessary expenses that ought to be eliminated. Financial ratios can also determine if the financial resources are over- or under-utilized.
Categories of Financial Ratios
There are numerous financial ratios that are used for ratio analysis, and they are grouped into the following categories:
1. Liquidity ratios
Liquidity ratios measure a company’s ability to meet its debt obligations as they come using its current assets. When a company is experiencing financial difficulties and is unable to pay its debts, it can convert its assets into cash and use the money to settle any pending debts with ease.
Some common liquidity ratios include quick ratio, cash ratio, and current ratio. Liquidity ratios are used by banks, creditors, and suppliers to determine if a client has the ability to honor their financial obligations as they come.
2. Solvency ratios
Solvency ratios measure a company’s long-term financial viability, and if they can stay solvent in the long term by paying debt and accumulated interests. The ratio compares the debt levels of a company to its assets, equity, and annual earnings.
Important solvency ratios include debt to capital ratio, debt ratio, interest coverage ratio, equity multiplier, etc. Solvency ratios are mainly used by governments, banks, employees, and institutional investors.
3. Profitability Ratios
Profitability ratios measure a business’ ability to earn profits that are relative to their associated expenses. Recording a higher profitability ratio relative to a similar ratio in the previous financial reporting period shows that the business is healthy. The profitability ratio can also be compared to a similar firm’s relative value to determine how profitable the business is.
Some examples of important profitability ratios include return on equity, return on assets, profit margin, gross margin, and return on capital employed.
4. Efficiency ratios
Efficiency ratios measure how well the business is using its assets and liabilities to generate sales and earn profits. It calculates the use of inventory, machinery utilization, turnover of liabilities, as well as the usage of equity. The ratios are important because, when there is an improvement in the efficiency ratios, the business stands to generate more revenues and profits.
Some of the important efficiency ratios include asset turnover ratio, inventory turnover, payables turnover, working capital turnover, fixed asset turnover, receivables turnover, etc.
5. Coverage ratios
Coverage ratios measure a business’ ability to service its debts and other obligations related to the debt. Analysts can use the coverage ratios across several reporting periods to draw a trend that predicts the company’s financial position in the future. A higher coverage ratio means that a business can service its debts and associated obligations with ease.
Key coverage ratios include debt coverage, interest coverage, fixed charge coverage, EBIDTA coverage, etc.
6. Market prospect ratios
Market prospect ratios help investors to predict how much they will earn from specific investments. The earnings can be in the form of higher stock value or future dividends. Investors can use current earnings and dividends to determine how much the stock prices will be in the future, and the dividends they should expect to earn.
Key market prospect ratios include dividend yield, earnings per share, price-to-earnings ratio, and dividend payout ratio.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: