Ratio analysis

July 27, 2023
10 MIN READ
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Ratio analysis examines line-item data from a company's financial records to elicit information about cash flow, operational effectiveness, profitability, and solvency. Ratio analysis may show how a firm has changed over time and compare one company to another in the same company or sector. External parties that establish standards sometimes connected to risk may also need ratio analysis. While ratios provide important information about a firm, they should be combined with other measures to provide a more complete view of its financial health. The current ratio, gross profit margin ratio, and inventory turnover ratio are examples of ratio analysis.

What is ratio analysis?

The study of numerous pieces of financial data in a company's financial statements is referred to as ratio analysis. External analysts mostly utilize them to assess different characteristics of a corporation, such as liquidity, financial viability, and viability. Analysts depend on current and historical financial accounts to assess a company's financial performance. They utilize the data to analyze if a company's financial health is improving or deteriorating and compare it to other competitive businesses.

The concept of ratio analysis

Investors and analysts utilize ratio analysis to assess a company's financial health by evaluating previous and present financial statements. Comparative data may show how a firm has performed over time and be used to forecast probable future performance. This data may also be used to compare a firm's financial condition to industry averages and to determine how a company compares to others in the same industry. Investors may readily apply ratio analysis, and all of the figures required to compute the ratios can be found on the financial documents of a business.

Companies use ratios to compare themselves. They assess stocks within a certain industry. Similarly, they compare a company's current metrics to its previous ones. In most situations, understanding the elements driving ratios is also crucial since management can change its approach to make its' stock and business ratios more appealing. Ratios are generally employed in conjunction with other ratios rather than alone. Knowing the ratios in each of the four already-stated categories will provide you with a full picture of the organization from many perspectives and assist you in spotting possible red flags. A ratio is a relationship between two values that shows how often one value includes or is contained inside the other.

Categories of ratio analysis 

Several financial ratios are employed for ratio analysis and thus are classified as follows:

     i. Ratios of liquidity

The capacity of a corporation to satisfy its debt commitments using current assets is measured by liquidity ratios. When a corporation has financial problems and fails to pay its bills, it could turn its assets into cash and utilize the money to pay off any outstanding debts more easily.

The fast ratio, cash ratio, and current ratio are all examples of typical liquidity ratios. Financial institutions, lenders, and suppliers use liquidity measures to evaluate whether customers can meet their financial commitments when they come due.

·       Current ratio

Because it is a rapid, intuitive, and simple metric to grasp the link between current assets and liabilities, the current ratio is the most often used to gauge a company's liquidity.

Current ratio = Current assets / Current liabilities

The current ratio gives us a general approximation of whether the firm can last for a year. If current assets exceed current obligations, we conclude that the firm may sell its current assets and settle its current obligations while still surviving for at least one operational cycle. It does not give us complete information on current assets' worth and whether they are feasible. If the current assets are mostly receivables, we should look at the collectability of those receivables. If our current assets include many stocks, we should remember that inventories take time to convert into cash since they cannot be easily sold. Receivables are much more liquid than inventories.

·       Fast ratio analysis

Current assets may comprise large volumes of goods, prepaid costs, etc. Because current ratios are not highly liquid, this may distort interpretations. To overcome this problem, using just the most liquid assets, such as the financial assets and receivables, should give us a more accurate picture of the coverage of short-term liabilities. It is referred to as the acid test or the quick ratio. A good acid test score is 1.0, as a rule of reference.

·       Cash ratio

The cash coverage ratio includes cash and its equivalent (the most liquid assets under Current Assets). A larger cash ratio indicates the corporation is inclined to meet its short-term creditors.

     ii. Solvency factors

Solvency ratios assess a business's long-term financial sustainability. These ratios measure a company's debt to its securities, equity, or yearly profits. Debt-to-capital ratios, debt ratios, interest coverage ratios, and equity multipliers are essential solvency measures. Governments, banks, workers, and institutional investors are the primary users of liquidity ratios.

     iii. Earnings potential Ratios

Profitability ratios assess a company's capacity to generate profits for its costs. A greater profitability ratio than in the preceding financial reporting period indicates that the firm is financially improving. A profitability ratio may also be compared to the ratio of a comparable company to discover how lucrative the business is compared to its rivals. Important profitability ratios include return on equity, profit margin, gross margin, return on assets, and return on capital utilized.

     iv. Ratios of efficiency

Efficiency ratios assess how successfully a company uses its financial assets and liabilities to create sales and profits. They compute inventory utilization, equipment utilization, liability turnover, and equity utilization. These ratios are crucial because as the efficiency ratios improve, the firm stands to earn more sales and profits. Several essential efficiency ratios include the asset turnover ratio, inventory turnover, payables turnover, working capital turnover, fixed asset turnover, and receivables turnover ratio.

·       Receivables days

Accounts Receivable Turnover is closely related to days receivable. Days receivables convey the same data regarding the number of days every year. It gives a simple way to calculate Receivables Collection Days.

·       Inventory turnover ratio

The Inventory Ratio indicates how often inventories are replenished throughout the year. It is determined by dividing the Cost of Goods Sold by the Inventory.

·       Inventory days

Consider inventory days to be the sum of days required for inventory to be converted into a final product.

Inventory days = Number of days in a year / Inventory turnover

·       Accounts payable turnover

The number of times payables is rotated over the period is indicated by payable turnover. Because purchases create accounts payable, it is best assessed against purchases.

Payable turnover = Purchases / Accounts payable

·       Days payable ratio

Payable days are the average number of days a firm takes to pay its suppliers.

Days payable = Total number of days in a year / Payable turnover

The more accounts payable days, the more advantageous it is for the organization's liquidity. Seasonality in the company might have an impact on payable days. Because of the next business cycle, a company may store up inventory.

·       The cycle of cash conversion

The overall period the company requires to convert its cash expenditures into cash returns is called the cash conversion cycle. Consider the cash conversion cycle, the time it takes a corporation to acquire raw materials, convert inventories into completed products, sell the product and get cash, and finally make the appropriate purchase payment.

Cash conversion cycle = (Receivable days + Inventory days - Payable days)

It represents the days the firm's cash is trapped in company activities. A lengthier cash conversion cycle indicates that the organization takes longer to earn cash returns. A corporation with a lower cash conversion cycle, on the other hand, may be considered healthy. Additionally, the cash conversion cycle should be compared to the market standard so that we may remark on the higher/lower end of the cash conversion cycle.

     v. Ratios of coverage

Coverage ratios assess a company's capacity to cover its debts and other liabilities. Analysts may utilize coverage ratios from many reporting periods to create a trend that forecasts the company's financial status in the future. An elevated coverage ratio indicates that a company can easily fulfill its debts and related obligations. The debt coverage ratio, interest coverage, fixed charge coverage, and EBIDTA coverage are important.

     vi. Prospective market ratios

Market prospect ratios assist investors in predicting how much money they will gain from certain assets. Earnings might take the shape of increased stock value or future payouts. Investors may use current profits and dividends to help predict the likely future price of shares and dividends. Dividend yield, earnings per share, the price-to-earnings ratio, and the dividend payout ratio are all important market prospect ratios.

Uses of ratio analysis

The basic idea behind ratio analysis is to evaluate numerous data and determine a computed value. That value may have little to no worth on its own. Instead, ratio analysis is often used to identify whether the financial stability of a business is robust, weak, improving, or declining.

     i. Analysis of Ratios Over Time

A corporation may undertake ratio analysis throughout time to have a better knowledge of its company's trajectory. Instead of focusing on where it is now, the organization is more interested in how it has fared through time, what improvements were successful, and what perils remain. Ratio analysis is an important aspect of making long-term choices and strategic planning.

To undertake ratio analysis over time, a corporation regularly chooses and analyzes a single financial ratio (for example, computing its quick ratio every month). Consider seasonality and how temporary changes in account balances may affect month-over-month ratio computations. The firm then examines how the ratio has changed (if it is improving, at what pace it is shifting, and whether it desired the ratio to improve over time).

     ii. Across-company ratio analysis

Consider a corporation with a gross profit margin of 10%. This financial ratio may excite a corporation until every rival achieves a gross profit margin of 25%. Ratio analysis may help a firm understand how its efficiency compares to comparable companies.

Consider examining comparable firms within the same sector when using ratio analysis to contrast various companies. Furthermore, remember how differing financial structures and business sizes might affect a firm's efficiency potential. Consider how organizations with distinct product lines (for example, certain technology firms may provide goods and services, two separate product lines with differing influences on ratio analysis) operate.

Different sectors have different expectations for ratios. A debt-equity ratio is acceptable for a utility firm that can access low-cost financing but may be considered unsustainable for a technological company that depends significantly on private investor investment.

     iii. Ratio analysis to standards

Companies might establish internal financial ratio objectives. These estimates may aim to maintain present levels or to increase operational growth. For instance, if the current ratio of an organization is 1.1, and it wishes to become more liquid, it may establish an internal goal of having a current ratio of 1.2 by the conclusion of the current financial year.

External participants, such as creditors, commonly use standards. Lending organizations often include financial stability criteria as part of loan covenants. Covenants are part of the terms and conditions of a loan, and businesses must meet specific criteria, or the loan may be repaid.

If these standards are not fulfilled, the whole loan may be called, or a corporation may be confronted with an increased interest rate to compensate for the risk. A creditor's benchmark is frequently the debt service coverage ratio, which compares an organization's cash flow to its debt amounts.

Conclusion

Sometimes an overwhelming quantity of data and information is available to help a corporation make choices. A corporation may compare various statistics to use its knowledge better. This approach, known as ratio analysis, enables a firm to understand better how it performs over time against competitors and internal objectives. Although ratio analysis may be conducted using non-financial data, it is often based on financial measurements.