Ratio Analysis – Have you tried analyzing financial statements? If you look at the balanced sheet, income statement or the cash flow at first it would be really difficult to judge or start analyzing it. To make this process simpler and also get some definite conclusions about the financial statements, we need certain measures which would help us in the same.
What is Ratio Analysis?
Ratio analysis is one such tool that would aid us to interpret the financial statements in terms of the operating performance and financial position of a firm. It comprises comparison for a meaningful interpretation of ratio analysis of financial statements which in turn plays a vital role in business planning process. It involves comparing the ratios with similar firms in the industry or analyzing the trend in the same company over a period of time. This analysis is one very important and most basic part of fundamental analysis process.
Before moving ahead and start understanding the key ratios lets understand what a “ratio” is. A ratio communicates the relationship between one accounting outcome and another, which provides a valuable comparison.
The aim of this article is to provide you with a guide to ratio analysis, learn about ratios, their meaning and computation. There are several financial ratios available we are going to discuss the most widely used and categorized into the following broad areas.
- Liquidity ratios
- Profitability ratios
- Turnover ratios
- Debt ratios
If you are new to finance, then you may want to look at Accounting for Beginners
Let’s discuss each category and its ratios briefly:
Ratio Analysis – Liquidity ratios
These are the ratios that quantity if the company would be able to meet its short term debt commitments/current liabilities and pay them off when they are due. They depict if the cash and cash equivalents are enough to cover the short term debt commitments. If the value of the ratio is greater than 1 it shows that the ratio analysis of the company is liquid and in good financial health but if it is less than one it shows failure to meet obligations.
The following ratios would help in determining the liquidity of a company:
- This measures the short term solvency of the company using the ratio analysis in balance sheet. Also known as the working capital ratio, it tells if a firm has sufficient funds to pay its liabilities over the period of next 12 months.
- It shows if the company is efficient in converting its product into cash (operating cycle).
- The ratio analysis current ratio can also give a sense of the efficiency of a company’s operating cycle or its ability to turn its product into cash.
- Possible creditors could use it to deciding whether or not to give short-term loans.
Formula: – Current ratio = Current Assets/ Current liabilities
Quick ratio/acid test ratio:
- It measures the current short term solvency of the company.
- It considers if the very liquid assets (can be converted into cash immediately) are available to meet the obligations.
Formula: Quick ratio = Quick assets (Current assets- Inventory)/Current liabilities
- Cash ratio further refines the current ratio and quick ratio.
- It considers only the most liquid short-term assets of the company, which are those that can be most easily used to pay off existing commitments and hence it is the most stringent measure among the three liquidity ratios.
Formula: Cash ratio = Cash and cash equivalents/Current liabilities
Ratio Analysis – Profitability Ratios
Profitability ratios measure firms operating competence i.e. how well it utilized the available resources in order to generate profit, including its ability to generate income and hence cash flow. Cash flow directly affects the company’s capability to take debt and equity financing. Therefore calculation of this ratio becomes significant to know how effectively the ratio analysis profitability of the company is being managed.
In most of these ratios higher the ratio better for the company as it implies the business is generating revenue and is profitable. Again in order to draw meaningful ratio analysis conclusions it is necessary to do a comparison i.e. conduct trend analysis or industry analysis.
While analyzing the profitability of the company the nature of the business under scan should be considered, for instance if the business sis seasonal it would not have the same profitability throughout the year.
Profitability ratio can be further divided into two groups;
Profitability ratio in relations to sales
Gross profit margin/ratio
- It is measure to show by how much gross profit exceed production costs.
- It is generally expressed in the form a percentage and discloses how much a firm makes after considering all the production costs such as materials, labor etc. and its ratio analysis efficiency in managing those costs.
Formula: Gross profit margin = Gross profit margin = Gross profit / Net sales*100
Net profit margin/ratio
- It shows management’s efficiency in manufacturing, administrating, and selling the products and the costs it incurs there.
- It shows the amount of revenue left after all the expenses have been paid off.
Formula: Net profit margin = Earnings after tax/Net sales*100
Operating profit margin/ratio
- This ratio specifies how much profit a firm makes after paying for variable costs of production such as wages, raw materials, etc. but before interest and tax
Formula: Operating profit margin =EBIT/ Net sales*100
This ratio can be used to know the behavior of each cost with respect to sales. The various ratios could be;
Expense Ratio Formulas # 1 – Cost of goods sold = Cost of goods sold/Net sales*100
Expense Ratio Formulas # 2 – Administrative Expenses Ratio = Administrative Expenses Net sales*100
Expense Ratio Formulas # 3 – Selling and distribution expenses ratio = Selling and distribution expenses/Net sales*100