What is Ratio Analysis?
Ratio analysis is the analysis of the financial statements in conjunction with the interpretations of the financial results of any particular period of operations, which are derived with the help of ‘ratio’. It is employed for evaluating the financial soundness of a business concern. In this article, we are going to study ratio analysis in detail.
Ratio analysis is a way to interpret the balance sheet and income statement of a company to learn about its liquidity, operation, efficiency, and profitability. Rather than one single measure, ratio analysis is a way of analyzing a variety of financial data with respect to a company. Ratio analysis is the backbone of fundamental equity analysis.
There are many different ratios that investors and other business experts can go over to predict a company’s ability to sustain its financial resources and grow in the future. They can be used to either track how a company’s performance has changed over time or compare how a given company tracks with others of a similar kind in its industry.
Types of ratio analysis
There are five broad heads under which the available financial ratios can be classified based on the type of data they provide.
Liquidity Ratio: Liquidity ratio measures a company’s a company’s ability to liquidate its short-term debt as they come to maturity, using a company’s current and quick assets. Liquidity ratio include:
Current ratio
Quick ratio
Working capital ratio
Solvency ratio: Solvency ratio also called financial leverage ratio, it compares the level of debt of a company with its assets, earning and equity. These can be used to determine the chances of survival of the firm to a long term by liquidating long-term debt and paying off its interest. solvency ratios include:
Debt-assets ratio
Debt-equity ratio
Interest coverage ratio
Profitability ratio: Profitability ratio evaluate a company’s ability to generate profit related to its operations. Profitability ratio include:
Profit margin ratio
Gross margin ratio
Return of assets (ROA)
Return of equity (ROE)
Return on capital employed (ROCE)
Growth ratio: The growth ratio tells you about the growth rate of the company. It will give you an idea whether your company growth increased or decreased. Growth ratio include:
Revenue growth
Earning before interest and tax (EBIT) growth
Net profit growth
Earnings per share (EPS) growth
Market valuation ratio: Market valuation ratio is commonly used ratio; they used this metrics to predict earning and future performance. Market valuation ratio include:
Profit-to-earning (P/E) ratio
Dividend yield ratio
Earnings per share (EPS) ratio
Dividend payout ratio
Importance of Ratio Analysis
Test of solvency: Ratios can highlight the solvency of a firm. For example, if the current assets over current liabilities is rising, then it implies that there is sufficient working capital. Thus, it will not be difficult to pay the creditors.
Helps in making decision: Primary roles of financial statements include informing the users about the financial position of the company, while at the same time it acts as a decision-making aid for managerial personnel.
Helps in future forecasting and planning: Analysts and managers can plot a trend, use the direction as an indication for their future projection, and be used for key decision-making by external stakeholders such as investors. For example, they can determine whether they should put money into a project or not.
Helps to find profitability: Ratios are also useful in comparing different companies’ profitability levels. For example, current and past ratios can be compared to establish trends of a company’s past and potential future performance.
To compare performance of the company: Main Uses of Ratio Analysis The main use of ratio analysis is to compare the strengths and weaknesses of each firm. Comparison with Similar Firms The ratios can also be compared to the firm’s previous ratio and help analyze whether the company has progressed.
Liquidity position of company: Healthy inferences regarding the liquidity position of the firm can be carried out by using ratio analysis. Liquidity determines whether the firm is able to pay its short-term obligations or not. By short-term obligations we mean short-term debts, which one can pay within 12 months, or the operating cycle.
Analysis the operational efficiency: From a management point of view, ratios allow managers to measure the efficiency of assets. A test of higher efficiency will be a situation when sales and, consequently, their contribution to net profit increase every year.
Business trends: Ratio analysis can reveal trends that the managers might take corrective action on.
Helps in cost controlling: Ratio analysis is helpful to evaluate performance and facilitate cost control.
Helps in analyzing financial health in corporate: The following are information about liquidity, solvency, profitability, and capital gearing, which can be provided by ratio analysis. Hence, these are valuable tools for learning about financial health.
Helps in identifying the business risk: One of the most important reasons one uses ratio analysis is the fact that it helps to understand the firm’s business. Calculating the leverages (the financial leverage and the operating leverages) allows the firm to understand the business risk, i.e., how its profitability is sensitive to its fixed cost deployment and outstanding debt.
Analysis the financial statement: This interpretation of the financial statements and data is of significant importance to both the firm’s internal and external stakeholders. To simplify this for analysis, we make use of ratio analysis by interpreting the numbers from the balance sheet and income statements. Every stakeholder is interested in the financial results differently. Equity investors are more interested in the growth of dividend payments and the earnings power of the organization in the long run. Creditors would want to be paid for their repayments in time, as regards their dues.
Ratio Analysis in Investment Banking (IB)
Financial analysis is also applied in the assessment of investment opportunities. An investment banker goes through income statements, balance sheets, and even cash flow statements to project whether a business is profitable and sustainable. By analyzing them, he can trace patterns and trends or potential problems that have an impact on the future of the company.
Financial ratio analysis is also another facet where financial analysis in investment banking helps. The ratios, such as liquidity ratios, profitability ratios, and leverage ratios, give information of immense importance and value to the financial strength and performance of the company.
These ratios serve as tools used by investment bankers in comparing companies in the same industry or sector so as to make proper investment decisions.
Investment banks: It is very difficult for a normal investor to evaluate an investment bank properly. General rules of stockpicking apply, that is, profitability is good, rising dividends are better, and cash flow should be sustainable, but there are some additional metrics with a particular relevance for investment banks. Some of the equity metrics of shareholders include the form of liabilities, debt to total capital ratios, return on capital employed, and return on assets.
Conclusion
There is always so much information and data that is useful to any company in order to make an effective decision. In order to better utilize their information, a firm may compare multiple numbers together.
This process known as ratio analysis allows a firm to gain greater insights into how it is working overtime, in competition, and against internal goals. Ratio analysis is typically rooted heavily in financial metrics, although ratio analysis can be conducted using non-financial data.