Ratio analysis is a fundamental analysis tool to check the financial performance of a company. Learn its types and applications.
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3 mins read
10Apr2024
Ratio analysis is a widely used fundamental analysis tool. It helps us see how well a company is doing financially. Whether you are just starting to invest, learning about finance, or running your own business, knowing about ratio analysis can help you make smart financial choices.
It lets you know where to put your money, how to manage your budget and plan for the future. Let’s understand the ratio analysis definition, its types, and practical application.
What is ratio analysis?
Ratio analysis is an examination and interpretation of various financial ratios to assess a company's:
 Profitability
 Liquidity
 Solvency, and
 Efficiency
These ratios are derived from a company's financial statements, which typically include the balance sheet, income statement, and cash flow statement. By comparing different ratios over time or against industry benchmarks, you can gain valuable insights into a company's financial performance.
How does ratio analysis help?
Ratio analysis serves several key purposes and helps investors in making better investment decisions. Let’s see them:
Performance evaluation
 Ratio analysis helps in evaluating the financial performance of a company over time.
 By examining trends in ratios you can assess whether a company’s financial health is:
 Improving
 Stagnating, or
 Declining
Comparison with industry benchmarks
 Ratio analysis allows for comparisons with industry benchmarks or standards.
 You can compare a company's ratios against:
 Industry averages or
 Competitors' performance
 This comparison helps you to:
 Identify areas of strength or weakness and
 Assess relative performance within the industry.
Identification of financial trends
 By examining ratios you can identify financial trends and patterns that can impact future performance.
 For example,
 A declining trend in profitability ratios signals inefficiencies or competitive pressures
 While an improving trend in liquidity ratios indicates a strengthened financial position
What are the types of ratio analysis?
Ratio analysis can be divided into four different types or categories. Let us see them:
Type I: Liquidity Ratios
Liquidity ratios help us see if a company can meet its shortterm obligations on time. This type can be further divided into:
 Current ratio and
 Quick ratio
Aspects/Liquidity ratios  Current ratio  Quick ratio (or Acidtest ratio) 
Meaning  This ratio measures the company's ability to pay off its shortterm liabilities with its shortterm assets.  Unlike the current ratio, the quick ratio excludes inventory and prepaid expenses from current assets. This exclusion provides for a more conservative measure of liquidity. 
Formula  Current Assets / Current Liabilities  Quick Assets* / Current Liabilities Quick assets = Current Assets  Inventory  Prepaid expenses 
Ideal ratios 


Type II: Profitability Ratios
Profitability ratios help us understand how good a company is at making money relative to its revenue, assets, and liabilities. Let us understand these terms first:
Revenue
 This is how much money the company makes from selling its products or services.
 Profitability ratios show if the company is making enough profit compared to its revenue.
Assets
 These are things the company owns, like buildings, equipment, or cash.
 Profitability ratios help us see if the company is making good use of its assets to earn profits.
Equity
 This is the value of what's left for the company's owners after paying off all debts.
 Profitability ratios tell us if the company is earning enough profit for its owners compared to the money they've invested.
The profitability ratios can be further subdivided into three different types:
 Gross profit margin
 Net profit margin, and
 Return on equity (ROE)
Aspects/Profitability ratios  Gross profit margin  Net profit margin  Return on Equity (ROE) 
Meaning  This ratio measures the portion of revenue that remains after subtracting the cost of goods sold (COGS).  The net profit margin measures the percentage of revenue that remains after deducting all expenses, including taxes and interest.  ROE indicates how efficiently a company generates profits from its shareholders' equity. 
Formula  (Revenue  COGS) / Revenue × 100  (Net Income / Revenue) × 100  (Net Income / Shareholders' Equity) × 100 
Type III: Solvency Ratios
Solvency ratios help us figure out if a company can handle its longterm financial obligations. Knowing this is crucial for several reasons:
A company with strong solvency ratios is seen as less risky and more attractive for investment, while companies with weak solvency ratios are viewed with caution.
Creditors, such as banks and bondholders, use solvency ratios to assess a company's ability to repay its debts. A company with favourable solvency ratios is more likely to receive:
Favourable loan terms and
Lower interest rates
By monitoring solvency ratios you can get early warning signs of potential financial distress.
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Solvency ratios can be further divided into two subtypes:
 Debttoequity ratio
 Interest coverage ratio
Aspects/Solvency ratios  Debttoequity ratio  Interest coverage ratio 
Meaning 


Formula  Total Debt / Shareholders' Equity  EBIT / Interest Expenses 
Ideal ratio 


Type IV: Efficiency Ratios
Efficiency ratios evaluate how effectively a company utilises its resources to generate revenue and manage its operations. We can further divide them into:
Inventory turnover ratio and
Accounts receivable turnover ratio
Aspects/Efficiency ratios  Inventory turnover ratio  Accounts receivable turnover ratio 
Meaning  This ratio measures how many times a company sells and replaces its inventory within a specific period.  This ratio assesses how efficiently a company collects payments from its customers. 
Formula  Cost of Goods Sold (COGS) / Average Inventory  Net Credit Sales / Average Accounts Receivable 
Example of Ratio analysis
ABC Enterprises is a manufacturing company engaged in the business of making LED lights. It has returned the following financial figures for the year ending March 31, 2024:
 Total Debt: Rs. 5,00,000
 Shareholders' Equity: Rs. 10,00,000
 Earnings Before Interest and Taxes (EBIT): Rs. 7,00,000
 Interest Expenses: Rs. 1,00,000
 Gross Profit: Rs. 15,00,000
 Net Profit: Rs. 8,00,000
 Revenue: Rs. 30,00,000
 Inventory at the Beginning of the Year: Rs. 2,00,000
 Inventory at the End of the Year: Rs. 1,50,000
 Accounts Receivable at the Beginning of the Year: Rs. 1,50,000
 Accounts Receivable at the End of the Year: Rs. 2,00,000
 Current Assets: Rs. 8,00,000
 Current Liabilities: Rs. 3,00,000
 Cash and Cash Equivalents: Rs. 2,50,000
 Purchases: Rs. 5,00,000
 Direct Expenses: Rs. 4,50,000
 Net Credit Sales = Rs. 20,00,000
Based on the above data, now, let's calculate the specified ratios:
Type of Ratio  Formula  Calculation  Ratio 
DebttoEquity Ratio  Total Debt / Shareholders' Equity  Rs. 5,00,000 / Rs. 10,00,000  0.5 
Interest Coverage Ratio  EBIT / Interest Expenses  Rs. 7,00,000 / Rs. 1,00,000  7 
Gross Profit Margin  (Gross Profit / Revenue) × 100  (Rs. 15,00,000 / Rs. 30,00,000) × 100  50% 
Net Profit Margin  (Net Profit / Revenue) × 100  (Rs. 8,00,000 / Rs. 30,00,000) × 100  26.67% 
Return on Equity (ROE)  (Net Profit / Shareholders' Equity) × 100  (Rs. 8,00,000 / Rs. 10,00,000) × 100  80% 
Current Ratio  Current Assets / Current Liabilities  Rs. 8,00,000 / Rs. 3,00,000  2.67 
Quick Ratio (Acidtest Ratio  (Current Assets  Inventory) / Current Liabilities  (Rs. 8,00,000  Rs. 1,50,000) / Rs. 3,00,000  2.17 
Inventory Turnover Ratio  Cost of Goods Sold (COGS) / Average Inventory  COGS = 2,00,000 + 5,00,000 + 4,50,000 1,50,000 = 10,00,000 Average Inventory = (Rs. 2,00,000 + Rs. 1,50,000) / 2 = 1,75,000 Inventory turnover ratio = 10,00,000/ 1,75,000 = 5.71  5.71 
Accounts Receivable Turnover Ratio  Net Credit Sales / Average Accounts Receivable  Average Accounts Receivable = (Rs. 1,50,000 + Rs. 2,00,000) / 2 = Rs. 1,75,000 Accounts Receivable Turnover Ratio = Rs. 20,00,000 / Rs. 1,75,000 = 11.43  11.43 
What can we observe?
Based on the calculated ratios and financial figures for ABC Enterprises, we can make several common observations:
 DebttoEquity Ratio (0.5)
 ABC Enterprises has a relatively conservative capital structure, with a lower proportion of debt compared to equity.
 This indicates a lower financial risk and less reliance on borrowed funds for financing its operations.
 Interest Coverage Ratio (7)
 The interest coverage ratio of 7 indicates that ABC Enterprises is generating sufficient earnings to cover its interest expenses comfortably.
 This suggests a strong ability to meet its interest obligations and indicates financial stability.
 Gross Profit Margin (50%)
 ABC Enterprises has a healthy gross profit margin of 50%, indicating that it:
 Effectively manages its production costs and
 Generates a significant profit margin on its products.
 This suggests efficient cost management and pricing strategies.
 ABC Enterprises has a healthy gross profit margin of 50%, indicating that it:
 Net Profit Margin (26.67%)
 The net profit margin of 26.67% indicates that ABC Enterprises retains approximately 26.67% of its revenue as net profit after accounting for all expenses and taxes.
 This reflects efficient operations and effective management of expenses.
 Return on Equity (ROE) (80%)
 ABC Enterprises achieves an impressive return on equity of 80%, indicating that it generates significant profits relative to the shareholders' equity invested in the company.
 This suggests efficient utilisation of shareholders' funds to generate returns.
 Current Ratio (2.67) and Quick Ratio (2.17)
 ABC Enterprises has a current ratio of 2.67 and a quick ratio of 2.17, indicating a healthy liquidity position.
 The current assets are more than sufficient to cover its shortterm liabilities
 Inventory Turnover Ratio (5.71)
 The inventory turnover ratio of 5.71 suggests that ABC Enterprises efficiently manages its inventory by quickly selling and replenishing stock.
 This indicates effective inventory management and avoids holding excess inventory.
 Accounts Receivable Turnover Ratio (11.43)
 ABC Enterprises has a high accounts receivable turnover ratio of 11.43, indicating that it efficiently collects payments from its customers.
 This suggests:
 Effective credit management and
 Timely collection of receivables
Conclusion
Ratio analysis is a powerful tool that helps in performing a fundamental analysis of a company. It helps investors know about the financial performance of a company which is key to making smart investment decisions.
We can divide ratio analysis into four broad categories with each making different indications. Through liquidity ratios, you can gauge a company's ability to meet its shortterm obligations, while profitability ratios shed light on its ability to generate profits from its operations. Solvency ratios provide insights into a company's longterm financial stability, and efficiency ratios offer clues about its operational effectiveness.
By comparing a company's ratios to industry benchmarks, historical trends, and competitors' performance, you can understand which companies to pick and invest in.
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Frequently asked questions
What do you mean by ratio analysis?
Ratio analysis are fundamental analysis tool. By comparing them with industry benchmarks, you can assess the financial health of a company.
What are the four types of ratio analysis?
Ratio analysis can be divided into four types, which are:
 Liquidity ratios
 Solvency ratios
 Profitability ratios, and
 Efficiency ratios
Where can I find financial data to conduct ratio analysis?
Financial data required for ratio analysis can typically be found in a company's financial statements, including the balance sheet, income statement, and cash flow statement. This information is often available in annual reports, quarterly filings with regulatory authorities, and financial databases.
Can ratio analysis be used for different types of companies?
Yes, ratio analysis can be applied to companies of all sizes and across different industries. However, the choice of ratios and benchmarks may vary depending on the specific characteristics of the company and its industry.
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