What Are Ratio Analysis Types?
Ratio Analysis Types refer to different forms of ratio analyses that are conducted to figure out the exact status or progress of a business. The ratio analysis forms help analyze the company’s financial and trend of the company’s results over years. It is a fundamental tool that every company uses to ascertain the financial liquidity, debt burden, profitability, and how well it is placed in the market compared to its peers.
Some of the categories of ratio analysis include liquidity ratios, solvency ratios, profitability ratios, efficiency ratio, and coverage ratio which indicates the company’s performance. Various examples of these ratios include the current ratio, return on equity, debt-equity ratio, dividend payout ratio, and price-earnings ratio. These different types of ratio analysis make financial analysis easier to conduct for companies, thereby helping them plan their progress accordingly.
Table of contents
- What Are Ratio Analysis Types?
- Ratio Analysis Types Explained
- Top 5 Types of Ratio Analysis
- Frequently Asked Questions (FAQs)
- Recommended Articles
- . Ratio analysis is a helpful tool for assessing a company's financial health and progress over time. It involves analyzing five categories of ratios, including liquidity, solvency, profitability, efficiency, and coverage. These ratios can give you valuable insights into the company's performance.
- Profitability ratios, solvency ratios, liquidity ratios, turnover ratios, and earning ratios are five types of ratio analysis.
- Financial analysis in companies can benefit from various types of ratio analysis. Top management can use it as a crucial tool for strategic business planning.
Ratio Analysis Types Explained
Ratio analysis types exist in several form and based on the figures and assessment data that firms need to generate to understand its progress or decline, the analysts choose a specific type of it for further calculation and quantitative derivations. This is because not all ratio analysis type suits all kinds of requirements of a business. Hence, the ratio to be calculated for analysis must be chosen based on the kind of data required for it.
Though there are five widely used types of ratio analysis, choosing a random type may not help firms assess their current position in the market. For example, if a business desires to check its debt-to-equity ratio, it has to compute this particular ration for valid figures. Finding out gross profit ratio in such a scenario would not help organizations.
Therefore, it is important to choose the appropriate ratio analysis type for a more accurate and reliable overview of the business performance. So far as being correct in deriving a proper conclusion is concerned, multiple ratio analysis should be conducted for better support to the figures obtained. If more ratio analysis suggests growth, that means the business is on the right track. The numerator and denominator of the ratio to be calculated are taken from the financial statements, thereby expressing a relationship with each other. This is done based on the type of ratio selected for analysis. For example, if a business wants to learn about the returns expected on the capital employed, the numerator will be Earnings Before Interests and Taxes (EBIT) and the denominator will be the capital employed. On the other hand, if the ratio to be obtained is the return on net worth, the numerator and denominator would be different, i.e., net profit and equity shareholder’s funds, respectively.
The above mentioned are some ratios analysis types that the company can use for its financial analysis. In this way, ratio analysis is a very important tool for any kind of strategic business planning by the company's top management.
Top 5 Types of Ratio Analysis
Every company has calculated different types of ratios analysis to evaluate business performance. The details of each one of them have been mentioned below for better clarity of ratio analysis types as a concept as well as its calculation:
Type #1 - Profitability Ratios
This type of ratio analysis suggests the returns generated from the Business with the Capital Invested.
Gross Profit Ratio
It represents the company's operating profit after adjusting the cost of the goods that are sold. The higher the gross profit ratio, the lower the cost of goods sold, and the greater satisfaction for the management.
Gross Profit Ratio Formula = Gross Profit/Net Sales*100.
Net Profit Ratio
It represents the company's overall profitability after deducting all the cash & no cash expenses: the higher the net profit ratio, the higher the net worth, and the stronger the balance sheet.
Net Profit Ratio Formula = Net Profit/Net Sales*100
Operating Profit Ratio
It represents the soundness of the company and the ability to pay off its debt obligations.
Operating Profit Ratio Formula = Ebit/Net sales*100
Return on Capital Employed
ROCE represents the company's profitability with the capital invested in the business.
Return on Capital Employed Formula = Ebit/Capital Employed
Type #2 - Solvency Ratios
These ratio analysis types suggest whether the company is solvent & can pay off the lenders' debts or not.
Debt-Equity Ratio
This ratio represents the leverage of the company. A low d/e ratio means that the company has a lesser amount of debt on its books and is more equity diluted. A 2:1 is an ideal debt-equity ratio to be maintained by any company.
Debt Equity Ratio Formula = Total Debt/Shareholders Fund.
Where, total debt = long term + short term + other fixed payments shareholder funds = equity share capital + reserves + preference share capital – fictitious assets.
Interest Coverage Ratio
It represents how many times the company’s profits can cover its interest expense. It also signifies the company's solvency shortly since the higher the ratio, the more comfort to the shareholders & lenders regarding servicing of the debt obligations and smooth functioning of the business operations of the company.
Interest Coverage Ratio Formula = Ebit/Interest Expense
Type #3 - Liquidity Ratios
These ratios represent whether the company has enough liquidity to meet its short-term obligations or not. Higher liquidity ratios are more cash-rich for the company.
Current Ratio
It represents the company's liquidity to meet its obligations in the next 12 months. Higher the current ratio, the stronger the company to pay its current liabilities. However, a very high current ratio signifies that a lot of money is stuck in receivables that might not be realized in the future.
Formula = Current Assets / Current Liablities
Quick Ratio
It represents how cash-rich the company is to pay off its immediate liabilities in the short term.
Quick Ratio Formula = Cash & Cash Equivalents+Marketable Securities+Accounts Receivables/Current Liabilities
Type #4 - Turnover Ratios
These ratios signify how efficiently the assets and liabilities of the company are used to generate revenue.
Fixed Assets Turnover Ratio
Fixed asset turnover represents the efficiency of the company to generate revenue from its assets. In simple terms, it is a return on the investment in fixed assets. Net Sales = Gross Sales – Returns. Net Fixed Assets = Gross Fixed Assets –Accumulated Depreciation.
Average Net Fixed Assets = (Opening Balance of Net Fixed Assets + Closing Balance of Net Fixed Assets)/2.
Fixed Assets Turnover Ratio Formula = Net Sales / Average Fixed Assets
Inventory Turnover Ratio
The Inventory Turnover Ratio represents how fast the company can convert its inventory into sales. It is calculated in days signifying the time required to sell the stock on an average. The average inventory is considered in this formula since the company's inventory keeps on fluctuating throughout the year.
Inventory Turnover Ratio Formula = Cost of Goods Sold/Average Inventories
Receivable Turnover Ratio
Receivables Turnover Ratio reflects the efficiency of the company to collect its receivables. It signifies how many times the receivables are converted to cash. A higher receivable turnover ratio also indicates that the company is collecting money in cash.
Receivables Turnover Ratio Formula = Net Credit Sales/Average Receivables
#5 - Earning Ratios
This ratio analysis type speaks about the company's returns for its shareholders or investors.
P/E Ratio
PE Ratio represents the company's earnings multiple and the market value of the shares based on the pe multiple. A high P/E Ratio is a positive sign for the company since it gets a high valuation in the market for m&a opportunities.
P/E Ratio Formula = Market Price per Share/Earnings Per Share
Earnings Per Share represents the monetary value of the earnings of each shareholder. It is one of the major components looked at by the analyst while investing in equity markets.
Earnings Per Share Formula =(Net Income – Preferred Dividends) / (Weighted Average of Shares Outstanding)
Return on Net Worth
It represents how much profit the company generated with the invested capital from equity & preference shareholders both.
Return on Net Worth Formula = Net Profit/Equity Shareholder Funds. Equity Funds = Equity+Preference+Reserves -Fictitious Assets.
Frequently Asked Questions (FAQs)
What are the three types of ratio analysis?
There are three types of ratio analysis. The first is the current ratio, which measures a company's ability to pay short-term liabilities with existing assets. The second is the quick ratio, the acid test ratio, which measures the ability to pay short-term liabilities with quick assets. The third is the cash ratio.
What is the use of ratio analysis?
Examining every detail of a company's financial statements, ratio analysis helps assess its overall economic well-being. It lets you determine whether a company's financial health has improved or declined. Furthermore, you can compare a company's financials to its peers or the industry through ratio analysis.
Who uses ratio analysis?
External analysts primarily perform ratio analysis using financial statements as their primary source of information. These analysts obtain essential data to assess a company's economic performance by analyzing current and past financial statements.
Recommended Articles
This article has been a guide to what are Ratio Analysis Types. We explain the top 5 types of it - Profitability, Solvency, Liquidity, Turnover & Earnings Ratios. You can learn more about financing from the following articles –
- Limitations of Ratio Analysis
- Why Ratio Analysis is Important?
- Advantages of Ratio Analysis
- Financial Ratios Types
