4 Best Financial Ratio Analysis Technique Discussed Briefly

Ratio Analysis – Have you tried analyzing financial statements? If you look at the balanced sheet, income statement, or 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 the 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 the fundamental analysis process.

Before moving ahead and start understanding the key ratios let’s 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.

1. Liquidity ratios
2. Profitability ratios
3. Turnover ratios
4. 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:

Current ratio:

• 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

• 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.

The profitability ratio can be further divided into two groups;

Profitability ratio in relations to sales

Gross profit margin/ratio

• It is a measure to show by how much gross profit exceeds 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

Expenses Ratio

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

Return on investment (ROI)

• Return on investment (ROI) is a performance measure which evaluates the efficiency of an investment.
• It compares the gains from investment directly to the investment costs.
• It is a universally used approach for evaluating the financial magnitudes of business investments, decisions, or actions.

Formula: Return on investment = Net profit after interest and tax / Total Assets

Return on Equity (ROE)

• Return on equity (ROE) discloses the amount of profit a firm made compared to the total amount of shareholders equity.
• It is considered to be one of the most important financial ratios and indicator of profitability.

Formula: ROE = Net profit after tax / Shareholder’s equity

Return on assets (ROA)

• It indicates the profitability ratios of a firm in relation to all the resources/assets of a company.
• Compared to other profitability ratios it considers all the assets hence helps in determining its efficiency in terms of utilizing all its assets to generate profitability

Formula: ROA = Net profit after tax / Total assets (or Average Total assets)

Return on capital employed (ROCE)

• This ratio measures the returns a firm gets out of the total capital employed by them.
• Generally expressed in form of a percentage a ROCE is considered to be good when it is greater than the rate at which the firm has been borrowing capital.

Formula: ROCE = EBIT / (Total Assets – Current Liabilities)

Ratio Analysis – Turnover ratios

It indicates the firm’s efficiency with respect to its asset management. It shows how the business has been utilizing its assets in order to make revenue.

The standard of this ratio is industry-specific and depends upon the requirement of assets. The following turnover ratios can be used to analyze the effectiveness of asset use.

Inventory Turnover Ratio

• This ratio is a metric that indicates the number of times inventory has been converted into sales in a particular period of time and hence can be an effective tool for inventory management.

Formula: Inventory turnover ratio = Cost of goods sold / Average Inventory; Inventory turnover days = 365 / Inventory turnover

Debtor Turnover Ratio

• Also known as the receivable turnover ratio/ accounts receivable turnover ratio, it how quickly a firm collects outstanding cash from its customers/debtors in an accounting period.
• It also determines if the firm is having problems in converting their credit sales into cash.

Formula – Debtors turnover ratio = Net receivable sales/ Average debtors; Average collection period = 365 / Debtors turnover ratio

Creditor Turnover Ratio

• Also known as the accounts payable turnover ratio it evaluates how quickly the business spays off its creditors/suppliers in a particular period.
• It can help the firm in analyzing how it has been handling its payments.

Formula: Creditors turnover ratio = Total purchases / Average creditors; Purchases = Cost of sales + Ending inventory – beginning inventory; Days Payable Outstanding (DPO) = 365 / Creditors turnover ratio

Assets Turnover Ratio

• This ratio compares the sales revenue of a company to its assets.
• It depicts how efficiently and effectively the firm has been utilizing its assets.
• Higher the ratio better is the utilization.

Formula: Asset Turnover Ratio = Sales Revenue / Total Assets

Ratio Analysis – Debt ratios

Debt to equity ratio

• The debt-to-equity ratio indicates the relative portion of entity’s equity and debt used to fund the assets. It helps in examining the health of the company.
• Financial lenders prefer a low debt to equity ratio before considering to give any debt. Hence if this ratio is high it may not attract additional lending.
• The standard for this ratio would be industry specific but optimal would be considered 1 i.e. when the liabilities are equal to equity.

Formula: Debt to equity ratio = Liabilities / Equity

Debt ratio

• This ratio indicates the amount of debt to the total amount of assets.
• It signifies the amount of debt the firm has been relying on to finance its assets.
• Higher the ratio greater is the risk related with the firm’s operation.

Formula: Debt ratio = Liabilities / Assets

Debt service coverage ratio

• This is a ratio considered to be the most important one from the lending institutions.
• It depicts the ability of the firm to pay back its principal loan amount and interest amount.
• A debt service coverage ratio which is below 1 indicates a negative cash flow

Formula: DSCR = (Annual Net Income + Interest Expense + Amortization & Depreciation + Other discretionary and non-cash items like non contractual provided by the management)/ (Principal Repayment + Interest Payments + Lease Payments)

For advanced training on Accounting, you can look at Accounting Training Advanced

Ratio Analysis – Other ratios

Earnings per share

• This ratio helps in measuring the profit that is available to the equity shareholders on a per-share basis.

Formula: Earnings per share = Earnings after tax – Preferred dividends/Equity shares outstanding

Dividend per share

• It is the dividends that have been paid to the shareholders on a per-share basis.

Formula: Dividend per share = Earnings paid to the ordinary shareholders/ Number of ordinary shares outstanding

Dividends payout ratio

• It accounts for the relationship between the earnings belonging to the equity shareholders and the dividends paid to them.

Formula: Dividends payout ratio = Dividend per share/Earnings per share

Price earnings ratio or P/E ratio

• It signifies the expectations of the investors for the stock. A P/E ratio greater than 15 has historically been considered high.

Formula: Price earnings (P/E) ratio = Market price of share/Earnings per share

Recommended Articles

Here are some articles that will help you to get more detail about the Financial Ratio Analysis so just go through the link.

1. Discounted Cash Flow
2. Financial planner business plan
3. Financially Intelligent Career Move
4. Tips to Get Better in Business and Finance