Ratio analysis is the cornerstone of the financial statement that is prepared to convey information about an organization's financial situation and cash flows. A business's accounts and financial statements are meticulously prepared to show the actual image of the company's operations.
Following the creation of financial statements, they must be evaluated using various tools. Ratio Analysis is a quantitative approach used to examine a company's financial status. It is done to help stakeholders comprehend the company's financial situation.
What is Ratio Analysis?
By analyzing a company's financial accounts, you can learn about its liquidity, operational efficiency, and profitability. Fundamental equity research relies heavily on ratio analysis. Profitability, liquidity, activity, debt, and market ratios are all used in ratio analysis to calculate financial performance.
They review and analyze the company using a variety of ratios. The comparison of various things in the business's financial statements is known as ratio analysis.
5 Types of Financial Ratios
The types of ratio analysis reveal different aspects of a company's financial health, ranging from debt coverage to asset use. Unless considered as a totality, a single ratio may not cover the company's complete performance.
Since they evaluate data that varies over time, these ratios are time-sensitive. So you can benefit from these ratios by comparing them across time periods to gain a general notion of a company's development or regression. Financial ratios are divided into five groups. Let's take a look at types of ratio analysis with formula -
Leverage Ratios
Solvency or leverage ratios provide information on a company's ability to pay down long-term loans. These statistics assess the company's reliance on debt for day-to-day operations as well as its ability to meet its obligations.
The following are some common leverage ratios:
Debt to Equity Ratios = Total Liabilities / Total Shareholders’ Equity | The debt-to-equity ratio compares a company's total debt to the capital provided by investors. |
Debt Ratio = Total Debt / Total Assets | The debt ratio is a calculation that compares a company's debt to its total assets. |
Interest Coverage Ratio = Earnings Before Interest and Tax / Interest Expense | The interest coverage ratio provides information on a company's ability to pay interest on its debts. |
Performance Ratios
Performance ratios, as the name implies, reveal a company's market performance (profit or loss). Profitability ratios are another name for these ratios.
The following are some popular profitability ratios:
Net Profit Margin = Net Profit / Revenue | The net profit margin is a measurement of the company's profit margins. A high net profit margin is an indication of a well-run company. |
Return on Equity = Net Income / Shareholders’ Equity | As shareholders' equity is equal to total assets minus debt, ROE is also known as return on net assets. |
Operating Profit Margin = Operating Profit / Revenue | The operating profit margin is the profit margin of a corporation before interest and taxes. |
Return on Assets = Net Income / Total Assets | The efficiency with which a corporation generates earnings from its assets is measured by its return on assets (ROA). |
Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue | The relationship between the company's gross sales and profits is revealed by the gross profit margin ratio. |
Liquidity Ratios
The ability of a corporation to pay its debt and other responsibilities is determined by liquidity ratios. You can tell if a company has enough assets to pay long-term obligations or if its cash flow is sufficient to cover overall expenses by looking at liquidity ratios. If the responses are affirmative, you can conclude that the corporation has sufficient liquidity; otherwise, there may be issues.
Liquidity ratios are especially important for small-cap and penny firms. Newer and smaller businesses frequently struggle to meet their costs until they reach a point of stability.
The following are some popular liquidity ratios:
Current Ratio = Current Assets / Current Liabilities | The current ratio will tell you how effectively the company will be able to satisfy its financial obligations over the next 12 months. |
Operating Cash Flow Margin = Cash from operating activities / Sales Revenue. | The operating cash flow margin represents the efficiency with which a company generates cash flow from sales and hence the quality of its profitability. |
Quick Ratio = (The Current Assets – Inventory)/Current Liabilities | The quick ratio - also known as the acid-test ratio, compares a company's cash, marketable securities, and receivables to its liabilities. This provides insight into the company's ability to meet its current obligations. |
Cash Ratio = (Cash + Cash Equivalents) / Total Liabilities | The cash ratio shows how much cash a company has in comparison to its total assets. |
Valuation Ratios
Valuation ratios are calculations that use a company's current share price to determine whether the stock is a good investment at the time. These ratios are also known as market ratios because they look at a company's stock market desirability.
The following are some popular valuation ratios:
Price to Sales Ratio (P/S) = Market Capitalization/Total Revenue | The P/S ratio compares a company's market capitalization to its sales over the previous year. It is a measure of the value investors get from a company's stock by reflecting how much they pay for shares per dollar of overall sales. |
Price to Earnings Ratio (P/E) = Price per share / Earnings per share | One of the most widely used financial statistics among investors to judge whether a firm is undervalued or overvalued is the price-to-earnings ratio (P/E). The ratio shows how much the market is ready to pay for a stock now based on its previous or projected earnings. |
PEG Ratio = Price to Earnings / Growth Rate | The PEG ratio - it is a valuation metric that calculates the relative trade-off between a company's stock price, earnings per share, and predicted growth. It enables comparing high-growth companies with a high P/E ratio to established companies with a lower P/E ratio easier. As a result, it is a more accurate measure of the stock's underlying value. |
Price/Cash Flow (P/CF) = Share Price / Operating Cash Flow per Share | This ratio compares the Price of a company's stock to the amount of cash it generates. The P/CF ratio has the advantage of being difficult to manipulate for a business. While accounting methods can modify Revenue and earnings, cash flow is relatively impervious to such changes. |
Activity Ratios
Activity ratios show how efficient a company's operations are. To put it another way, you can evaluate how well the company uses its resources, such as accessible assets, to generate Revenue.
The following are some examples of activity ratios:
Total asset turnover = Net Sales / Average Total Assets | The efficiency with which a corporation uses its assets to produce sales is measured by fixed asset turnover. |
Inventory turnover = Net Sales / Average Inventory at Selling Price. | This ratio might reveal how effectively a corporation manages its inventory. A high ratio indicates either high sales or little inventories. |
Fixed asset turnover = Net Sales / Average Fixed Assets. | The efficiency with which a corporation generates sales from its fixed assets - property, plant, and equipment – is measured by fixed asset turnover. |
Receivables turnover = Net Sales / Average accounts receivable | The turnover of receivables measures how quickly net sales are converted into cash. |
Payables turnover = Total supply purchase / Average Accounts Payable. | The accounts payable turnover ratio is the short-term liquidity indicator, and it displays the number of times a company's accounts payable are paid off in a given period. |
Also Read:5 Financial Ratios Every Investor Should Know
Limitations of the different types of financial ratios
- Ratio analysis might be misinterpreted due to insufficient or historical data.
- Future projections based on historical tendencies may not always be accurate or reliable.
- Ratio analysis is only beneficial if the analyst is knowledgeable and understands the method well.
- Also, because data is based on past data, ratio analysis may not always offer a realistic picture of the business.
- As organizations in different sectors may employ different accounting standards and operate in different environments, ratio analysis cannot be used to compare their performance.
