Ratio Analysis is the foundation of the Financial statement that is prepared to provide information about the financial position and cash flows of an organization. The accounts and financial statements of a business are created with careful accuracy that presents the true picture of the working of the business.
After the preparation of the financial statements, they need to be analyzed for which various tools are used. One such tool is Ratio Analysis, which is a quantitative tool used to assess the financial position of the business.
It is done for the stakeholders to get to understand the financial position of the firm.
Table of Contents
Ratio Analysis: Overview
Ratio analysis is a method of knowledge about the company’s liquidity, operational efficiency, and profitability by studying its financial statements. Ratio analysis is a cornerstone of fundamental equity analysis. Ratio analysis consists of calculating financial performance using five basic types of ratios: profitability, liquidity, activity, debt, and market.
They use various types of ratios to assess and analyze the company. Ratio Analysis is the comparison of the various items in the financial accounts of the business.
Ratio Analysis is used for various purposes:
- It is used to evaluate the liquidity, efficiency, and profitability of the business. It also helps the management to analyze the efficient use of financial resources.
- Ratio analysis can be used to compare the performance of the company to other firms in the industry. It helps the management to compare and improve the position of the company by taking appropriate decisions.
- Ratios are also used to identify any trend in the financial position of the company. These trends can be studied to predict future performance and decide the course of direction.
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Ratio Analysis Meaning
Ratio Analysis is the process of determining and interpreting the various aspects of financial statements. It is a statistical measure to define the relationship between two figures.
It is a mathematical method where the ratios calculated from the information in the financial statements are done to gain an insight into the company’s financial performance.
- Ratio analysis helps to evaluate the performance of the firm in terms of profitability, efficiency, and risk.
- Ratios provide meaningful comparisons of the various values in the financial statements.
- These ratios can be expressed as a percentage or a quotient.
Ratio Analysis Formula
Essentially, five types of Ratio analysis serve different purposes and are used to analyze different aspects of a firm.
These formulae are used to determine the profits, debts, liquidity, capital funds, and the overall profitability of the firm.
- For calculating the profitability of the business, the overall profitability ratio is used:
- Net Profit/ Total Assets
- To analyze the use of capital funds for various operations, Capital Structure Ratios are used. One such Capital Structure Ratio that can be used is the Debt Equity Ratio:
- Total Long Term Debts/ Shareholders Fund
- To calculate the liquidity of the firm, the current assets, and liabilities, we use the Liquidity Ratios:
- Current Ratio- Current Assets/ Current Liabilities
- To analyze the working capital needs and liquidity of the firm, Working Capital Ratios are used:
- Inventory Ratio- Net Sales/ Inventory
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Ratio Analysis Objectives
Analysis and Interpretation of the ratios require intelligence and skill as well as appropriate data to calculate the ratios. Ratio analysis is useful to various parties depending upon their needs and requirements.
Ratio analysis serves various purposes for the management of the business and its stakeholders:
- It indicates the strengths and weaknesses of the business.
- It helps in evaluating the liquidity, solvency, profitability as well as the level of efficiency of the business.
- It aims to provide reporting transparency to the stakeholders so that they measure the operative efficiency of the business.
- It also helps in budget preparation, proper utilization of assets and inter and intra company comparisons.
- It helps in predicting the future course of action of the business.
- It also helps in reviewing the past trends of the management.
Ratio Analysis Formula
Investors and Analysts can use various types of ratios depending upon the objective of the analysis to evaluate the financial position of the firm. Various simple formulae can be used to calculate these ratios.
Calculating the ratios is a simple and easy task and provides useful insight into the management and investors upon interpretation.
The formulae for the most commonly used Ratio Analysis Formula are given below:
Current Ratio=Current Assets/ Current Liabilities
Quick Ratio=Liquid Assets/ Current Liabilities
Gross Profit Ratio=Gross Profit/ Net Sales X 100
Operating Profit Ratio= Operating Profit/ Net sales X 100
Return on Investment Ratio= Net Profit after Interest and Taxes/ Shareholders’ funds X 100
Inventory Ratio= Net Sales/ Inventory
Working Capital Turnover Ratio= Net Sales/ Working Capital
Debt to Equity Ratio= Total Long-term Debts/ Shareholders Funds
Overall Profitability Ratio= Net Profit/ Total Assets
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Ratio Analysis Types
In terms of financial statement analysis, financial ratios are divided into broad categories, depending upon the objective of the analysis. An analyst needs to have complete knowledge of what each type of financial ratio means and what aspect of the business it highlights.
The major broad categories of financial ratios with their subtypes are-
- Liquidity Ratios– Liquidity ratios show the cash availability of a business and its ability to meet its short term obligations. In essence, it indicates how quickly the assets and liabilities of the company can be converted to cash to meet its short-term obligations. Different liquidity ratios are- Current Ratio, Quick Ratio, Absolute Liquid Ratio.
- Profitability Ratios– Profitability Ratios indicates the effectiveness of the business, how it uses its assets and equity to generate profit. Different profitability ratios are- Gross Profit Ratio, Operating Cost Ratio, Operating Profit Ratio, Net Profit Ratio, Return on Investment Ratio, Price Earnings Ratio, etc.
- Working Capital Ratios– It also analyses the efficient use of working capital by the company and how well the company can pay off its current debts using the assets. Examples pf Working Capital Ratios are- Inventory Ratio, Debtors Turnover Ratio, Debt Collection Ratio, Working Capital Turnover Ratio.
- Capital Structure Ratios– It analyses how the company utilizes its capital or funds. Examples- Debt to Equity Ratio, Proprietary Ratio, Debt Service Ratio
Ratio Analysis Limitations
Although Ratio analysis has various advantages as it is the most commonly used tool for analyzing financial statements and interpreting various accounting equations.
Despite its usefulness and advantages, it has its own set of limitations:
- Inadequate or historical data can lead to misinterpretation of ratio analysis.
- Future predictions depending upon past trends may not always be correct and dependable.
- Ratio analysis is only useful if the analyst is skilled and has complete knowledge of the process.
- Ratio analysis may not always present a realistic picture of the business as the data is based on historical data.
- Ratio Analysis cannot be used to compare the performance of companies from different sectors as they may have different accounting practices and work in a different environment.
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Financial Ratio Analysis
Financial Ratios are the quantitative, mathematical comparisons of the various aspects of a financial statement that helps the investors, management, creditors to understand how well or not the company is performing.
Financial ratios allow big and small companies to evaluate and improve their financial position and market standing.
Financial Ratio Analysis is an aspect of the long-term trend analysis:
- Financial Ratios are widely used tools of analysis used by the companies to evaluate their performance.
- Since ratios are fairly easy to understand and compute, any company can use it as a tool of analysis as it does not take into account the size of the company.
- Financial Ratio Analysis is only useful if the accounts of the company are consistent and the information provided does not vary from one period to another.
Financial Ratio Analysis and Interpretation
Though financial ratios are an important tool to analyze the financial position of the company, accurately interpreting these calculated ratios is also very important. Interpretation of financial ratios requires skill, intelligence and a clear understanding of the financial accounts.
To make the calculated ratios useful, they should be further interpreted.
- Single absolute ratios, for example, 2:1; can be interpreted as being an indicator of better performance and liquidity. It is considered to be a good ratio of current assets to current liabilities.
- To draw more accurate conclusions, a single ratio can be combined with other related ratios that make the interpretation more meaningful.
- Ratios can also be interpreted from past comparisons. But while doing so, the changes in the market trends and the company’s accounting procedures should be kept in mind.
- The interpretation of different ratios should be done depending upon the objective of the analysis as well as the accuracy of the financial statements.
Current Ratio Analysis
Current Ratio is a type of Liquidity ratios and is the most commonly used ratio by firms to calculate their liquidity. It is used by analysts to determine their ability to pay short-term debts like tax payable, wages or salaries.
Current assets and liabilities are the components of the balance sheet that can be converted to cash within a year. The current ratio calculates how the firm can pay its short-term debts based on its current assets and liabilities.
- Current Assets and Current Liabilities gives us the Current Ratio.
- The formula to calculate Current Ratio is- Current Assets/ Current Liabilities
- If the current ratio is more than 1, then the business is in a position to pay its short-term debts without any stress. If the current ratio is less than 1, then the business will have difficulty in paying its bills.
- A higher current ratio is desirable over a lower current ratio to maintain liquidity.
Ratio Analysis of Financial Statements
The preparation of financial statements at the end of each accounting period is the most important process for any small or large business. The three main financial statements are the balance sheet, income statement and cash flow statement.
Management uses these financial statements to operate the business and also to provide transparency to the stakeholders.
- Investors and Analysts can analyze the financial statements using Vertical analysis, Horizontal analysis or Ratio analysis.
- The process of reviewing the entire financial statements is a time-consuming process and so the stakeholders make use of the ratio analysis to evaluate the performance of the business.
- Several calculated ratios can be analyzed together and compared with past trends to adequately determine the financial standing of the business.
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Ratio Analysis in Accounting
The ratio is an expression of a relationship between two or more items in mathematical terms. Then, the exhibition of a relationship between various accounting data is called Accounting Ratio.
Ratios are useful in drawing meaningful conclusions about the performance of the business. Comparative analysis and interpretation of accounting data using ratios is an important aspect of providing transparent information to the stakeholders.
- Ratios may be expressed as a:b, in terms of fractions, integers, or percentages.
- Analysts need to have a clear understanding of how to interpret a given ratio to make the information useful.
- Ratio analysis is not much use for the management, as they have the access to the financial statements to analyze their performance, it is more useful to the various stakeholders to determine the future trends in the business.
- Ratio analysis establishes for the stakeholders’ whether the business is profitable or not.
Liquidity Ratio Analysis
Liquidity Ratios are used to determine the business to meet its debt obligations using its current assets and liabilities. Companies can convert their liquid assets into cash to overcome any financial difficulty and pay off its debts and obligations.
It takes into account the liquid assets and short-term liabilities.
- Liquidity ratios are useful for banks, creditors and suppliers to determine if the firm is capable of paying its obligations as they come.
- Liquidity Ratios include Current Ratio, Quick Ratio and Absolute Liquid Ratio or Cash Ratio.
- These ratios indicate the efficiency of the business to liquidate its assets and liabilities.
FAQs
Ans. Ratio Analysis refers to the comparisons between different types of financial information provided in the various financial statements of the companies. They are a useful source of information for external analysts.
Financial ratios aim to simplify and summarise the information given in the financial statements. Instead of reviewing the entire financial statements, external analysts can easily get an accurate image of the efficiency of the firm by studying the ratios. Financial Ratios also aim to present past defects and determine future trends in a particular aspect of the business.
Ans. The conclusions gained from ratio analysis are not much use for internal management as they have access to the financial statements. They are rather calculated for use by the investors and other stakeholders.
Ans. Accurate interpretation of ratios depends upon the credibility of the financial statements and skills of the analysts. It does not always present a true picture and has certain limitations of its own.
Ans. Ratio Analysis is a tool for measuring and assessing the financial position of the business. It is calculated irrespective of the size of the business.
Ans. To analyze the profitability of the business, analysts should calculate Gross Profit Ratio, Net Profit Ratio, Operating Profit Ratio and Return on Investment Ratio.
Ans. Single ratios like current ratio, quick ratio; can be used to analyze and interpret the efficiency and liquidity of the business. However, to gain more insights and better conclusions from the financial statements, relatable ratios should be combined.
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