What is Ratio Analysis - Definition, Types, and Examples (2024)

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 short-term obligations on time. This type can be further divided into:

• Current ratio and
• Quick ratio

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)

Type III: Solvency Ratios

Solvency ratios help us figure out if a company can handle its long-term 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:

• Debt-to-equity ratio

• Interest coverage 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

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:

What can we observe?

Based on the calculated ratios and financial figures for ABC Enterprises, we can make several common observations:

• Debt-to-Equity 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.

• 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 short-term 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 short-term obligations, while profitability ratios shed light on its ability to generate profits from its operations. Solvency ratios provide insights into a company's long-term 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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