What is Ratio Analysis? Explained Financial Ratio Analysis Concept
The financial ratio analysis is a great tool you can use to analyze the financial performance of your business as it sets the correlation between two or more components of your financial statement. It provides you with an insight into the company’s liquidity, profitability, and operational efficiency.
This blog aims to explain what is ratio analysis, its interpretation, formula, and uses of ratio analysis.
What is a Financial Ratio?
Irrespective of the size of a business, its financial health is a primary concern. How then can a company ascertain its economic status? That is what financial ratios do for a business — it shows the enterprise how financially strong they are.
The extraction of values from Financial statements like balance sheets, statements of changes in owner’s equity, cash flow statements, and income statements are Financial ratios (also known as accounting ratios). But for these values to be of any use to your business, there is a need to analyze them.
Financial ratios not only help a business in determining its performance, but their analysis also provides particular valuable insights into the liquidity, solvency, and operational efficiency of the business.
Let’s then move to what all businesses need to do — financial ratio analysis.
What is Financial Ratio Analysis?
The finance managers gather all information from the company’s financial statements to statistically conduct a Financial ratio analysis. They extract all numerical values from the company’s financial statistics, market surveys, and economic progress to ascertain two critical attributes to operate a business:
1. The Company’s Performance
- The accounting or finance department scrutinizes the company’s financial record to analyze the company’s performance over a fixed timeframe.
- The uses of ratio analysis are that its comparison with the concern’s past financial records detects its monetary value drifts.
2. Comparison with its Competitor’s Performance
- Financial ratio analysis reports the company’s standing against its competitors.
- Information about the competitor’s performance is critical for the business.
- Such a comparison indicates the company’s position in the market.
- It guides the business on what it should do to continue to perform well in the market.
- Small businesses can make the most out of the financial ratios to track their financial performance.
“One can say that figures lie. But figures, when used in financial arguments, seem to have the bad habit of expressing a small part of the truth forcibly.” – American Stock Broker and Author Fred Schwed
Types of the Financial Ratios
There are many kinds of financial ratios depending on the data sets that financial ratios provide. In this article, to facilitate a better understanding of the topic, the financial ratios are classified into five silos as follows:
1. Liquidity Ratios
These financial metrics take the companies’ current liquid or quick asset holding into account to ascertain its ability (liquidity) to repay its short and long-term debts as they fall due and its margin of safety. It indicates whether the business can fulfill its current debt obligations with the asset it holds or if it needs to raise external credit to pay off its liabilities.
It is a ratio that calculates the liquidity of your business to understand the capacity to meet short-term obligations.
A current ratio below 1 indicates poor liquidity of the business, and if it is more than 1.5 it is considered a good current ratio.
Acid-Test Ratio/Quick Ratio
The financial analyst considers the quick assets such as cash, marketable securities, or cash receivables to derive the acid-test ratio. Less liquid current assets like prepaid cash expenses or inventory are removed.
The Quick Ratio of 1 or more is considered good for business but if it falls below 1, it shows the business may struggle to meet higher current obligations against its lower liquid assets.
The cash ratio ascertains the liquidity of your business if you meet your short-term obligations by using only cash and cash equivalents and no other current assets.
There isn’t any precise benchmark for a cash ratio as it follows a conservative approach of using cash and equivalents only to repay its short-term debt and other current obligations.
So, for example, if your business has a cash ratio of less than 1, it does not mean your company is inefficient in meeting current obligations, you will still have other current assets such as inventory, prepayments, accounts receivables to meet your current liabilities.
Operating Cash Flow ratio
This ratio is used to understand how liquid are your operations to cover the near-term obligations. It uses the cash generated from the operating activities to understand whether it is sufficient to meet the obligations occurring during the next 12 months.
2. Leverage or Solvency Ratios
The Leverage financial ratios compare the company’s debt with its assets to know if the company is financially strong to carry on trade for the long term. For this purpose, the elements to consider are the long-term debt and interest thereof against the long-term assets, like equity and earnings.
The debt ratio measures how much portion of the total assets are financed by the debt. Debt ratios mostly change from company-to-company such as a capital-intensive company may represent a higher debt ratio.
However, a higher debt ratio is unfavorable to your business as it shows that majority of your assets are financed by the debt.
Debt to Equity Ratio
The debt to equity calculates how much debt the company is using to grow A higher debt to equity ratio is not favorable for a business, for it indicates the possibility of default. The debt to equity ratio predicts how the equity capital will cover liabilities at the time of its liquidation.
Interest Coverage Ratio
The interest coverage ratio indicates the margin of safety for a specific period. It is the number of times a company can pay interest on its debts with its current earnings. It would help if you had a high ratio of 1.5 or more to ensure that the company will have no issues paying interest on their debts.
The financial metric uses the company’s earnings before interest and taxes for calculation.
Debt-Service Coverage Ratio (DSCR)
The DSCR shows the financial stamina in closing its debts on time, and a high ratio indicates that it will not default in such payments. It means the business has earned sufficient income to cover the debt obligations that are due within 12 months.
Where the net operating income is derived by deducting certain operating expenses from the operating revenue of the business, the current liabilities will also include the current portion of the long-term debt (e,.g., interest payable for a long-term loan within 12 months).
3. Profitability Ratios
The Profitability Ratio is a metric to indicate the capacity of the company to earn profits against the revenue.
Gross Margin Ratio
These ratios show the company’s gross profits against its net sales, and it is the earning after deducting the merchandise costs.
A higher gross profit ratio represents that the company’s operations are profitable and your business is efficiently using its resources.
The Operating Margin Ratio
The ratio measures the operating income of a business against its net sales, and it is an excellent indicator of the company’s operational efficiency.
When this ratio is high, it represents that the company is stable and capable of covering its expenses from its primary operations.
Return on Assets (ROA)
ROA measures the profitability of your business against the total assets the capital that you invested in the company assets is generating desired profits for your business. A lower ROA shows your investment in the assets is not profitable enough.
Return on Equity (ROE)
The ROE measures the return percentage on the amount invested in the business. It indicates how efficiently a company is making profits using the investors’ money.
4. Efficiency Ratios
These ratios rate the company’s efficiency in using its assets and resources to increase returns from sales.
Asset Turnover Ratio
It measures how effective your business is in utilizing its assets to increase sales. A company that uses its resources wisely can effectively grow its sales, and the asset turnover ratio is a measurement to indicate that effectiveness.
A low asset turnover ratio is unfavorable as it shows you did not efficiently use your assets to produce revenue.
Inventory Turnover Ratio
This ratio indicates the number of times the company uses, sells, or replaces its inventory in a specific timeframe. For example, if an inventory turnover ratio is 10, it means the company can sell its inventory ten times in a given period.
The faster the inventory is sold, the more efficient company’s sales and operations are. A high inventory turnover ratio is favorable, while a low ratio indicates its poor performance in selling its inventory.
Accounts Receivable Turnover Ratio
These ratios show how quickly the company’s customers pay in a specific period.
Days Inventory Outstanding (DIO) Ratio
DIO refers to the number of days the inventory of your business requires to be converted into cash. The inventory turnover ratio tells you frequently your inventory gets converted into cash, while the DIO suggested within how many days it converts into cash.
A lower DIO is better for your small business as it represents you are efficiently selling your inventories without keeping them longer in the warehouse.
5. Market Prospect Ratios
These ratios are of immense value to investors to judge the future market rates of stocks and shares depending on their dividend measurements and current earnings.
It provides insights to the investors on the company’s share price as against its earnings. In simple terms, the P/E Ratio or the Price Multiple shows how much an investor would be willing to pay per share considering the company’s earning per dollar.
Hence, if your business has a higher P/E ratio, the investors will be ready to pay more amount for the share price of your company because they expect it to grow in the future.
Price to Cash Flow (P/CF) Ratio
The price to cash flow ratio is a measure of your company’s current share price to its operating cash flow that indicates the value of your share related to your operating cash flow.
Where the market capitalization is derived by multiplying the number of outstanding shares with the share price.
A low P/CF ratio represents the stock’s undervaluation; however, in the early stage of your business startup, you may have a higher P/CF ratio due to lower cash generation and future growth prospects, you may have a higher P/CF ratio.
Market to Book Ratio
Calculates your company’s current market value to its book value. It is mainly used for insurance, banking, real estate, and investment trust companies’ valuations.
A higher market-to-book ratio indicates that your company’s stocks have outperformed, while a lower ratio represents undervaluation.
Uses of Ratio Analysis
- Ratio analysis interests many as it reveals whether the financial status is financially sound, weak, or questionable, and it is a number one decision-aiding tool.
- It helps the managerial level make the correct decisions; predict, plan, communicate and validate the financial statements while also coordinating and effectively controlling the business.
- The investors and creditors analyze the ratios to measure the financial health of your business and how efficiently you are improving your business.
- Investors and shareholders choose the company only if they have favorable ratios.
- The favorable ratios encourage creditors to offer more extended credit periods to the business.
- Employees eagerly watch ratios to know if the company is doing well with the hope of earning higher salaries.
- The Government assesses the overall strength of the industry through financial ratio analysis.
- Significant variations in ratios help auditors make the necessary inquiries for tax computations.
Financial Ratio Analysis is the technique of analyzing and interpreting financial statements. It is essential for making the right management decisions. It is not the ultimate result but a means to understand the financial status by recognizing its weaknesses and strength.
Request your free demo at Upmetrics to input only the minimum elements so that we can compute it for you. We offer you accounting software that creates accurate financial statements and automatically calculates ratios to reveal whether your company is financially strong, weak, doubtful, or poor.