Ratio analysis is referred to as the study or analysis of the line items present in the financial statements of the company. It can be used to check various factors of a business such as profitability, liquidity, solvency and efficiency of the company or the business. Ratio analysis can mark how a company is performing over time, while comparing a company to another within the same industry or sector.
Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement. Ratio analysis is a cornerstone of fundamental equity analysis. It also helps in forecasting and planning by performing trend analysis. Helps in estimating budget for the firm by analysing previous trends. It helps in determining how efficiently a firm or an organisation is operating.
In general, there are four categories of ratio analysis:profitability, liquidity, solvency, and valuation. Common ratios include the price-to-earnings (P/E) ratio, net profit margin, and debt-to-equity (D/E).
The common financial ratios every business should track are 1) liquidity ratios 2) leverage ratios 3)efficiency ratio 4) profitability ratios and 5) market value ratios
Ratio analysis information is historic and not current. It does not take into account external factors such as a worldwide recession. Ratio analysis does not measure the human element of a firm/ companies. It can only be used for comparison with other firms/ companies of the same size and type.
It's a ratio that tells one's ability to pay off its debt as and when they become due I.e., how quickly a company can convert its current assets into cash so that it can pay off its liability on a timely basis.
Three liquidity ratios are commonly used – the current ratio, quick ratio, and cash ratio. In each of the liquidity ratios, the current liabilities amount is placed in the denominator of the equation, and the liquid assets amount is placed in the numerator.
A. Current Ratio
Current Ratio = Current Assets ÷ Current Liabilities
B. Quick Ratio
Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) ÷Current Liabilities
C. Cash Ratio
Cash Ratio = (Cash + Marketable Securities) ÷ Current Liabilities
2. Leverage ratios:
Any kind of financial ratio that indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. In short it is a financial measurements that assesses the ability of a company to meet its financial obligations.
Types of leverage ratios
A. Debt-to-Equity (D/E) Ratio: A high debt/equity ratio generally indicates that a company has been aggressive in financing its growth with debt
Debt-to-Equity Ratio= Total Liabilities ÷ Total Shareholders’ Equity
B. Equity Multiplier : Generally, it is better to have a low equity multiplier, as this means a company is not incurring excessive debt to finance its assets.
Equity Multiplier = Total Assets ÷ Total Equity
C. Debt-to-Capitalization Ratio : measures the amount of debt in a company’s capital structure.
Total debt to capitalization = (Short team + long term debt) ÷ (Short term + long term debt + share holders equity)
D. Debt Ratio : indicates how much debt a company uses to generate its assets
Debt Ratio = Total Debt ÷ Total Assets
E. Degree of Financial Leverage (DFL)
Degree of Financial Leverage = % Change in Earnings Per Share ÷ %Change in EBIT
F. Consumer Leverage Ratio
Consumer Leverage = Total Household Debt ÷ Disposable Income
3. Efficiency ratio : financial metrics that measure how efficiently a company uses its resources to generate revenue and profits. They reflect a company's ability to control its expenses and generate more output from its inputs.
A. Inventory turnover ratio : calculates the percentage of average inventory value to that of the cost of goods sold in an accounting period. In other words, the inventory turnaround ratio expresses, within a financial year, how many times a business is able to sell out its inventory in its entirety. The formula to calculate this ratio is
Inventory turnover ratio = Cost of goods sold / Average inventory value
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B. Asset turnover ratio : the percentage of revenue or sales generated by investing one percent of the company assets.
Asset turnover ratio = Net sales / Average total assets
C. Receivables turnover ratio : helps a business check the potency of the techniques used for revenue collection. As this ratio ultimately creates an impact on the cash flow and operations of the company.
Accounts receivable turnover ratio = Net credit sales / Average accounts receivable
D. Accounts payable turnover ratio : measure the percentage of net credit purchases against the average balance of accounts receivable.
Accounts payable turnover ratio = Net credit purchases / Average accounts payable
E. Day’s sale in inventory : this ratio helps in creating an estimate of how long will the current inventory or stock of the company last.
Day’s sales in inventory ratio = (Ending inventory/Cost of goods sold) x 365
4. Profitability Ratios : a type of accounting ratio that helps in determining the financial performance of business at the end of an accounting period. Profitability ratios show how well a company is able to make profits from its operations. Profitability ratios measure a company’s ability to generate profit relative to its sales, assets, and equity.
A. Margin Ratios : provide insights into a firm’s ability to generate profit from sales and the efficiency of its sales process
Gross Profit Margin : Gross Profit / Revenue
or
(Revenue - COGS) / Revenue
B. Operating Profit Margin : examines the business model’s profitability after accounting for production costs and running the business
EBIT Margin = EBIT / Revenue
Or
(Revenue - direct cost - operating costs) / Revenue
C. Net Profit Margin : answers this question by assessing the company’s overall profitability.
Net profit margin = Net profit / Revenue Or (Revenue - expense) / Revenue
D. Return on Asset : considers a company’s net profit (return) in relation to its capital. In other words, it evaluates whether the business makes enough profit given its size and the capital it employs.
ROA = Net income / Average total assets
E. Return on Equity : Reveals the return a company generates for owners or how much profit it makes relative to shareholders’ invested capital.
ROE = Net income / Average total equity
5. Market value Ratios : financial metrics that measure and analyze stock prices and compare market prices with those of competitors and against other facts and figures.
A. Book Value Per Share : it compares the market price and book value of a share to determine how close they are.
Book Value Per Share = (Equity share capital of the company + All reserves and surplus of shareholders) / Number of outstanding equity shares of the company
B. Earnings Per Share : determines the worth of a share to the investor
Earnings Per Share = (Net income - Preferred dividends) / Number of equity shares outstanding
C. Cash Earnings Per Share (CEPS) : also called operating cash flow
CEPS = Operating Cash Flow / Number of Shares Outstanding
D.Dividend Yield : calculates the return on investment for investors if they wish to buy shares at the current market price.
Dividend Yield = Annual dividend per share / Stock price of each share
E. Market Value Per Share : reveals the value that each share of a company’s stock has in the market. It is the core of all market value ratios as many other ratios are affected or determined by this value
Market Value Per Share = Total capitalization of the business / Number of shares outstanding
F. Price Earnings Ratio : It is measured as the current price of a share against the earnings the company has reported in that financial period for each share.
PE ratio = Market price per share / Earnings per share
