What is ratio analysis?
Ratio analysis is a method used to evaluate a company's financial performance by comparing various financial metrics to each other. The ratios are calculated from data found in a company's financial statements and are used to evaluate liquidity, solvency, profitability, and efficiency. Examples of ratios include the current ratio, debt-to-equity ratio, and return on equity. Ratios can be compared to industry averages or to the company's own historical performance to gain insights into the company's financial health. By analyzing these ratios, investors, analysts, and management can make informed decisions about a company's future prospects.
Objectives of ratio analysis?
Ratio analysis is a tool used to evaluate a company's financial performance by analyzing various financial ratios that are derived from its financial statements. The objectives of ratio analysis are:
1. To evaluate the financial performance and solvency of a company.
2. To compare the financial performance of a company with its past performance or with the industry standards.
3. To identify trends and patterns in a company's financial data over time.
4. To assess a company's liquidity, profitability, and efficiency.
5. To support decision-making by investors, creditors, and management.
Advantages of ratio analysis?
ratio analysis has several advantages, including:
1. Simplification of financial statements: Ratios simplify complex financial statements by expressing financial information in a more manageable form.
2. Trend analysis: Ratios can help to identify trends and changes over time, making it easier to identify areas of improvement or decline in a company's financial performance.
3. Comparison with industry standards: Ratios can be used to compare a company's performance with industry averages or standards, allowing for an objective evaluation of a company's financial position.
4. Identification of strengths and weaknesses: Ratios highlight a company's strengths and weaknesses, making it easier to identify areas for improvement and allocate resources effectively.
5. Assessment of liquidity, solvency, and profitability: Ratios can be used to assess a company's liquidity, solvency, and profitability, providing valuable insights into its financial health.
6. Decision making: Ratios can provide valuable information for decision making, such as whether to invest in a company or to extend credit to it.
Limitations of ratio analysis?
1. Historical data: Ratio analysis uses past financial data, which may not reflect current or future performance.
2. Limited comparability: Ratios can be misleading if compared with those of other companies in different industries or with different accounting practices.
3. Subjectivity: The choice of ratios and the way they are calculated can be subjective, leading to different conclusions.
4. Ignores qualitative factors: Ratios do not consider non-financial information such as a company's reputation, brand value, or management quality.
5. Doesn't consider inflation: Ratios do not take into account the effects of inflation, making it difficult to compare financial data over time.
6. Assumes stability: Ratios assume that a company's financial performance will remain stable, which may not always be the case.
7. Limited scope: Ratio analysis only provides a narrow view of a company's financial health and does not provide a complete picture of its overall financial situation.
Meaning and method of calculation of various types of ratios -
1. Current ratio :- The current ratio is a liquidity ratio that measures a company's ability to pay its short-term obligations. It is calculated by dividing a company's current assets by its current liabilities. The current ratio is used to assess a company's financial health and its ability to meet its short-term obligations. A current ratio of 1:1 means that a company has enough current assets to cover its current liabilities, and a ratio greater than 1 indicates that the company has more current assets than liabilities. However, a ratio less than 1 may indicate that a company may have difficulty paying its short-term obligations. The ideal current ratio varies by industry and the specific circumstances of a company.
It is calculated by applying the following formula :-
Current Ratio = Total Current Assets / Total Current Liabilities
Where,
Total Current Assets refer to the sum of all assets that can be reasonably converted to cash within a year, such as cash, accounts receivable, and inventory.
Total Current Liabilities refer to the sum of all debts and obligations that are due within a year, such as accounts payable, short-term loans, and accrued expenses.
2. Liquid ratio:- The Liquid Ratio, also known as the Quick Ratio, is a financial measure used to assess a company's ability to pay off its current liabilities using only its most liquid assets. It is calculated as:
Liquid Ratio = (Total Current Assets - Inventories) / Total Current Liabilities
Where,
Total Current Assets refer to the sum of all assets that can be reasonably converted to cash within a year, such as cash, accounts receivable, and marketable securities.
Inventories refer to the raw materials, work-in-progress, and finished goods that a company holds for sale.
Total Current Liabilities refer to the sum of all debts and obligations that are due within a year, such as accounts payable, short-term loans, and accrued expenses.
A liquid ratio of 1 or higher is considered healthy, indicating that a company has enough liquid assets to pay off its current liabilities. A ratio lower than 1 may indicate a potential liquidity issue.
3. Gross profit ratio:- Gross profit ratio is a financial metric that measures a company's ability to generate profit from its sales revenue. It is calculated as:
Gross Profit Ratio = (Gross Profit / Total Revenue) * 100
Where Gross Profit is calculated as Total Revenue minus the Cost of Goods Sold (COGS) and Total Revenue is the total sales made by the company.
This ratio provides insight into the company's pricing strategy, production efficiency, and overall financial health, as a higher gross profit margin indicates that the company is able to effectively manage its costs and generate more profit from its sales.
4. Net profit ratio:- Net profit ratio, also known as net profit margin, is a financial metric that measures the profitability of a company after accounting for all expenses, including both operating and non-operating expenses. It is calculated as:
Net Profit Ratio = (Net Profit / Total Revenue) * 100
Where Net Profit is calculated as Total Revenue minus all expenses (operating and non-operating) and Total Revenue is the total sales made by the company.
This ratio provides a comprehensive view of a company's overall financial health, as it reflects the amount of profit generated after accounting for all expenses. A higher net profit margin indicates that a company is more efficient in controlling its expenses and is more profitable.
5. Operating profit ratio:- Operating profit ratio, also known as operating profit margin, is a financial metric that measures a company's ability to generate profit from its core business operations. It is calculated as:
Operating Profit Ratio = (Operating Profit / Total Revenue) * 100
Where Operating Profit is calculated as Total Revenue minus all operating expenses and Total Revenue is the total sales made by the company. Operating expenses include cost of goods sold, selling and administrative expenses, and depreciation expenses.
This ratio provides insight into a company's efficiency in managing its day-to-day operations and controlling its costs, as a higher operating profit margin indicates that a company is able to generate more profit from its core business operations.
6. Operating ratio:- Operating ratio is a financial metric that measures a company's operating efficiency by comparing its operating expenses to its revenue. It is calculated as:
Operating Ratio = (Operating Expenses / Total Revenue) * 100
Where Operating Expenses are the expenses incurred in running the day-to-day operations of the business, such as cost of goods sold, selling and administrative expenses, and depreciation expenses. Total Revenue is the total sales made by the company.
A lower operating ratio indicates that a company is more efficient in controlling its expenses and is able to generate more profit from its operations. Conversely, a higher operating ratio indicates that a company has a higher operating expense to revenue ratio, which may indicate that the company is less efficient in controlling its costs.
7. Debt-to-equity ratio:- Debt-to-Equity Ratio (D/E Ratio) is a financial metric that measures the relationship between a company's debt and equity. It is calculated as:
Debt-to-Equity Ratio = Total Debt / Total Equity
Where Total Debt refers to the total amount of long-term debt and short-term debt that a company has, and Total Equity refers to the sum of a company's stockholders' equity and retained earnings.
The debt-to-equity ratio is used to assess a company's financial leverage and its ability to repay its debts. A higher debt-to-equity ratio indicates that a company has a higher proportion of debt in its capital structure, which may increase its risk of default. Conversely, a lower debt-to-equity ratio indicates that a company has a lower level of debt and a higher proportion of equity, which may indicate a stronger financial position.
8. Debt to total fund ratio:- The debt-to-total-funds ratio is a financial metric that measures the amount of debt a company has relative to the amount of funds it has available. It is expressed as a percentage and calculated as:
Debt-to-Total-Funds Ratio = (Total Debt / Total Funds) * 100
Where Total Debt refers to the sum of all the company's liabilities and Total Funds refers to the sum of all its assets. The ratio shows the proportion of the company's funds that are financed through debt and can be used to evaluate its financial leverage and overall financial health.
9. Proprietary ratio:- The proprietary ratio is a financial metric that indicates the proportion of a company's equity that is owned by its shareholders (proprietary equity) as compared to the equity held by its creditors (debt equity).
The formula for the proprietary ratio is:
Proprietary Ratio = Proprietary Equity / Total Equity
Where:
Proprietary Equity = Total Equity - Debt Equity
Total Equity = Share Capital + Reserves & Surplus.
10. Interest coverage ratio:- Interest coverage ratio is a financial metric that measures a company's ability to pay its interest expenses on its outstanding debt. It's calculated by dividing the company's earnings before interest and taxes (EBIT) by its interest expenses.
Formula: Interest Coverage Ratio = EBIT / Interest Expense
11. Capital turnover ratio:- Capital Turnover Ratio is a financial metric that measures a company's efficiency in using its capital to generate revenue. It's calculated by dividing a company's revenue by its total capital.
Formula: Capital Turnover Ratio = Revenue / Total Capital
12. Stock turnover ratio:- Stock Turnover Ratio is a financial metric that measures how many times a company's inventory is sold and replaced over a given period. It indicates how efficiently a company is using its inventory to generate revenue.
The formula for Stock Turnover Ratio is:
Stock Turnover Ratio = Cost of goods sold (COGS) / Average Inventory Value
Where,
Cost of goods sold (COGS) refers to the cost of the goods sold by a company during a given period
Average Inventory Value is calculated by adding the beginning and ending inventory values and dividing the sum by 2.
13. Debtors turnover ratio:- Debtors Turnover Ratio (also known as Accounts Receivable Turnover Ratio) is a financial metric used to measure how quickly a company collects payments from its customers. It indicates the efficiency of a company in converting its credit sales into cash. The higher the Debtors Turnover Ratio, the better a company is at collecting its outstanding receivables, and the less time its customers are taking to pay their bills.
The formula for Debtors Turnover Ratio is:
Debtors Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Where:
Net Credit Sales are the sales made on credit during a given period, after deducting any returns or allowances
Average Accounts Receivable is calculated by adding the beginning and ending balances of accounts receivable and dividing the sum by 2.
A high Debtors Turnover Ratio is a positive sign of good credit management and efficient collection of accounts receivable. On the other hand, a low Debtors Turnover Ratio may indicate slow collections or difficulties in collecting payments from customers, which can lead to increased pressure on a company's cash flow.
It is important to note that a high Debtors Turnover Ratio does not necessarily mean that a company is doing well, as there may be other factors that are affecting its collections. Therefore, it is recommended to analyze the Debtors Turnover Ratio in conjunction with other financial metrics and ratios to get a comprehensive view of a company's financial health.
14. Fix assets turnover ratio:- Fixed Assets Turnover Ratio is a financial metric that measures the efficiency with which a company is using its fixed assets to generate revenue. Fixed assets are long-term assets such as property, plant, and equipment that are used in a company's operations and have a useful life of more than one year. The Fixed Assets Turnover Ratio helps to determine how efficiently a company is utilizing its fixed assets to generate sales.
The formula for Fixed Assets Turnover Ratio is:
Fixed Assets Turnover Ratio = Net Sales / Total Fixed Assets
Where,
Net Sales is the total revenue generated by a company during a given period
Total Fixed Assets is the sum of all the company's fixed assets, such as property, plant, and equipment.
A high Fixed Assets Turnover Ratio indicates that a company is using its fixed assets effectively to generate sales, while a low Fixed Assets Turnover Ratio suggests that the company may not be fully utilizing its fixed assets or may have too much invested in fixed assets relative to its sales.
It is important to note that the Fixed Assets Turnover Ratio should be analyzed in conjunction with other financial metrics and ratios to get a comprehensive view of a company's financial health. A high Fixed Assets Turnover Ratio does not necessarily mean that a company is doing well, as there may be other factors affecting its sales and fixed assets utilization. Additionally, the Fixed Assets Turnover Ratio may be influenced by the industry in which the company operates, as some industries have higher capital requirements and investments in fixed assets than others.
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