Ratio Analysis: Meaning, Types and Benefits
Ratio analysis is a quantitative method of analysing a company’s financial statements to gain knowledge about its functional efficiency, profitability, liquidity, etc.
Let’s discuss the different aspects of ratio analysis in detail.
What do you understand by ratio analysis?
It is a process to thoroughly analyse and scrutinise the financial statements of a company to understand different aspects of its financial health. Many investors use this method to understand the company’s financials before investing in them. This is because it gives an overview of the company’s actual health based on publicly available data.
Investors should thoroughly go through the current and past year’s financial data to carry out ratio analysis. This analysis is very important as it not only provides a current status of the company’s health but also lets the organisations identify bottlenecks that are stopping them from attaining desired growth.
Now that you understand what ratio analysis is, let’s dig a bit deeper and understand its types.
What are the types of ratio analysis?
- Liquidity ratios
These ratios determine whether an organisation will be able to meet its liabilities from its existing pool of assets in the short run. There is a general principle that companies follow which allows them to convert their assets into liquid money to meet debt obligations whenever there is a shortage of resources to do so.
The different liquidity ratios are quick ratio, cash ratio, current ratio, etc. Banks and other financial institutions use this ratio commonly to assess the creditworthiness of their industrial clients.
- Profitability ratios
These ratios measure a company’s ability to earn profits. An increasing or improving profitability ratio over the last financial years directly implies that respective businesses have been steadily increasing their profits.
Moreover, you can also use these ratios to compare the profit levels of two companies. The different types of profitability ratios are gross profit margins, EBITDA margin, net profit margin, operating margin etc.
- Solvency ratios
As the name suggests, these ratios give an idea of the solvency of an organisation. In simpler words, we can say that it gives an idea regarding the long-term financial viability of a company. Analysts use different indicators, like the level of debt, annual earnings, and assets, to determine this ratio.
Some examples of solvency ratios include the debt-to-assets ratio, the interest coverage ratio, and the debt-to-equity (D/E) ratio. Users of solvency ratios are different financial institutions, governments, investors, and regulatory bodies.
- Market Prospect ratios
Market prospects ratios enable investors to anticipate their returns from certain investments, which can either be in the form of elevated stock prices or dividends. Investors try to predict future stock prices and dividends by utilising current earnings and dividends. Four crucial market prospect ratios are dividend yield, earnings per share, price-to-earnings ratio, and dividend payout ratio.
- Coverage ratio
It forecasts the future financial health and position of the company. A higher coverage ratio implies that respective organisations will be able to pay off their dues easily.
The interest coverage ratio, debt coverage ratio, and EBITDA coverage ratio are some of the common coverage ratios used by analysts.
What are the advantages of ratio analysis?
- Identification of trend
One of the biggest advantages of ratio analysis is that it helps companies to recognise a trend in their performance. Analysts who are carrying out a ratio analysis collate and compare financial data over several accounting years. This thorough study and understanding of the financial statements help in determining a trend that will further provide insights into its future performance.
- Helps in comparison with peers
Another major benefit of this quantitative analysis is that it assists in the comparison of the financial performance of two or more companies. As these ratios are numerical indicators, it becomes easy to compute a company’s performance by looking at the value itself.
- Operational efficiency
It assists companies in taking crucial operational decisions. Consequently, companies can go ahead or defer a particular managerial decision based on the analysis of the concerned ratios. Due to its simplicity and ease, ratio analysis is quite easy to understand. Therefore, it helps in quick decision-making on the part of management.
Who Can Use Ratio Analysis?
There is no bar on anyone for not using this indicator. However, as per conventional trends, the following stakeholders are the common users:
- Financial Managers
Different financial managers use these ratios to get an idea regarding the financial health of the company. This enables them to understand the problem and make necessary modifications on their part so that the financial health of the company improves.
Investors are another category of individuals that use these ratios on a large scale. They use these indicators to make appropriate investment decisions.
Entities like banks, Non-Banking financial companies (NBFCs), etc., who lend money to businesses, use these ratios and analyse a company’s credibility. After going through their past financial reports and data, creditors are in a better position to judge their clients.
Ratio analysis is an important tool used by different stakeholders to gauge a company’s financial standing. Moreover, it also allows companies to judge their standing with respect to their peers. However, if you are looking to make any investment, you must consider other tools and indicators as well and not rely on this alone.
Frequently Asked Questions
What is the formula of the Price to Earnings (PE) ratio?
To determine the PE value, companies can simply divide the prevailing market value of their shares by the earnings per share. The formula for the PE ratio is as follows:
PE = Current share price/Earnings per share
What is the drawback of the PE ratio?
One major drawback of the Price to Earnings (PE) ratio is that it can give false results if you are using it to compare the performance of two companies from different sectors. This is because both sectors have their complexities, and evaluation has to happen on a uniform basis.
What is the cash ratio?
The cash ratio comes under the liquidity ratio segment, and it measures the company’s ability to pay off its short-term debts by using cash and cash equivalents.
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
What are the objectives of ratio analysis?
Some major objectives of this quantitative analysis are to get an idea of the company’s operational and financial efficiency, and take measures to improve it or to make investment decisions.