Ratio Analysis

Introduction

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements. This form of financial statement analysis is based on several ratios that can be used by stakeholders and experts such as investors, creditors, and management to make better economic decisions. The ratios are derived from the financial statements of a company, including the balance sheet, income statement, and cash flow statement learn more.

Types of Ratios

There are several types of ratios that are commonly used in ratio analysis. These include:

Liquidity Ratios: These ratios measure the ability of a company to meet its short-term obligations. Examples include the current ratio, quick ratio, and cash ratio.
Profitability Ratios: These ratios measure the ability of a company to generate profits. Examples include the gross margin ratio, net profit margin, and return on equity.
Efficiency Ratios: These ratios measure how well a company uses its assets and liabilities internally. Examples include the asset turnover ratio, inventory turnover, and accounts receivable turnover ratio.
Solvency Ratios: These ratios measure the ability of a company to meet its long-term obligations. Examples include the debt to equity ratio, equity ratio, and times interest earned ratio.
Market Prospect Ratios: These ratios are used by investors to predict future movements in the company’s share price. Examples include the price to earnings ratio, dividend yield, and earnings per share.

Liquidity Ratios

Liquidity ratios measure a company's ability to pay off its short-term liabilities as they come due. The three most common liquidity ratios are the current ratio, the quick ratio, and the cash ratio.

Current Ratio: The current ratio is calculated by dividing current assets by current liabilities. It measures a company's ability to pay off its short-term liabilities with its short-term assets. A higher current ratio indicates a more promising current liquidity position of the company.
Quick Ratio: The quick ratio is calculated by subtracting inventories from current assets and then dividing by current liabilities. It is a more stringent measure of liquidity than the current ratio as it excludes inventories from current assets.
Cash Ratio: The cash ratio is calculated by dividing cash and cash equivalents by current liabilities. It is the most conservative liquidity ratio as it measures the ability of a company to pay off its current liabilities with just cash and cash equivalents.

A photo of a financial analyst reviewing liquidity ratios on a computer screen.

Profitability Ratios

Profitability ratios measure a company's ability to generate profits from its operations. The three most common profitability ratios are the gross margin ratio, the net profit margin, and the return on equity.

Gross Margin Ratio: The gross margin ratio is calculated by dividing gross profit by net sales. It measures the percentage of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services sold by the company.
Net Profit Margin: The net profit margin is calculated by dividing net profit by net sales. It measures the percentage of total sales revenue that the company retains after all expenses have been deducted.
Return on Equity: The return on equity is calculated by dividing net income by shareholder's equity. It measures the profitability of a company in relation to equity and shows how much profit a company generates with the money shareholders have invested.

Efficiency Ratios

Efficiency ratios measure how well a company uses its assets and liabilities internally. The three most common efficiency ratios are the asset turnover ratio, the inventory turnover, and the accounts receivable turnover ratio.

Asset Turnover Ratio: The asset turnover ratio is calculated by dividing net sales by total assets. It measures the efficiency of a company's use of its assets in generating sales revenue. The higher the ratio, the more efficiently the company is using its assets.
Inventory Turnover: The inventory turnover is calculated by dividing cost of goods sold by average inventory. It measures how many times a company's inventory is sold and replaced over a period.
Accounts Receivable Turnover Ratio: The accounts receivable turnover ratio is calculated by dividing net credit sales by average accounts receivable. It measures how effectively a company is managing its accounts receivable.

Solvency Ratios

Solvency ratios measure a company's ability to meet its long-term obligations. The three most common solvency ratios are the debt to equity ratio, the equity ratio, and the times interest earned ratio.

Debt to Equity Ratio: The debt to equity ratio is calculated by dividing total liabilities by shareholder's equity. It measures the financial leverage of a company and shows the proportion of debt and equity used by the company to finance its assets.
Equity Ratio: The equity ratio is calculated by dividing total equity by total assets. It measures the proportion of the total assets that are financed by stockholders and not creditors.
Times Interest Earned Ratio: The times interest earned ratio is calculated by dividing earnings before interest and taxes by interest expense. It measures the ability of a company to meet its interest expenses on outstanding debt.

Market Prospect Ratios

Market prospect ratios are used by investors to predict future movements in the company’s share price. The three most common market prospect ratios are the price to earnings ratio, the dividend yield, and the earnings per share.

Price to Earnings Ratio: The price to earnings ratio is calculated by dividing market value per share by earnings per share. It measures the price paid for a share relative to the annual net income earned by the firm per share.
Dividend Yield: The dividend yield is calculated by dividing annual dividends per share by market price per share. It measures the dividend return of a company's stock.
Earnings Per Share: The earnings per share is calculated by dividing net income by the number of outstanding shares. It measures the profitability of a company on a per share basis.

Advantages and Disadvantages of Ratio Analysis

Ratio analysis is a powerful tool of financial analysis. However, like any other analytical tool, it has its advantages and disadvantages.

Advantages

Simplification of Financial Statements: Ratio analysis simplifies the comprehension of financial statements. Ratios tell the story of changes in the financial condition of the business.
Comparative Analysis: Ratios provide a basis for comparison, whether it is comparing current performance with past performance or benchmarking against a competitor or an industry.
Early Warning System: Ratios serve as an early warning system, providing indications of potential problems or areas of strength and weakness.

Disadvantages

Not a Substitute for Judgement: Ratios are tools of analysis and, as such, cannot replace human judgement. They should not be used in isolation and must be interpreted in the context of other information.
Ignores Qualitative Factors: Ratio analysis is a quantitative tool and thus ignores qualitative factors such as management quality, brand recognition, market conditions, etc.
Accounting Methods: Different accounting methods can lead to different ratio values for companies that are otherwise identical.

Conclusion

Ratio analysis is a powerful tool for financial analysis. It provides valuable insights into a company's liquidity, operational efficiency, and profitability. However, like any other tool, it has its limitations and should not be used in isolation. It should be used in conjunction with other financial analysis tools and complemented with qualitative analysis for a comprehensive understanding of a company's financial health.