Profit-making is one of the most crucial obligations of management in a business. However, they cannot rely on the profit figures only. There are many factors at play before they arrive at the profit figures. The management must analyze all the factors from the financial statements to keep understanding the profitability in the short, medium, and long term. They use various numbers to understand the health of the business by performing ratio analysis. This article discusses the ratio analysis definition, its categories and its uses.
What does ratio analysis tell you?
Every company discloses its performance in its financial statements, which is the primary source of quantitative information. This financial statement reveals all the important information required to understand how the company has been performing in the past few years.
Using the various numbers present in the financial statements one can determine profitability, liquidity, solvency, etc. The company’s management uses this information to make strategic decisions like improving operations and optimizing profits.
Analysts and investors use this data to predict the performance of companies in the present and future. They also use it to compare it with market benchmarks and competition.
Ratio Analysis meaning
Ratio analysis means applying quantitative methods to information in a company’s financial statements, i.e., the balance sheet and income statement to know its financial standing. The different numbers in the statements are divided with each other logically, to arrive at ratios that are interpreted to reveal crucial aspects of the business.
Categories of Ratio Analysis
Financial Ratios are classified into various groups.
1. Liquidity Ratio
Liquidity means the amount of cash available (liquid cash). Liquidity ratios indicate the amount of money a company can generate in short periods. The liquid cash is received by selling its current assets. If the company is in debt then the liquidity ratio determines the amount of liquid cash it can generate to pay the debt.
Commonly used liquidity ratios are quick ratio, current ratio, cash ratio, etc. The liquidity ratio helps creditors, suppliers, and financial institutes like banks and loan companies to determine the ability of the company to meet its debt obligation.
2. Solvency ratio
Solvency ratios analyze a company’s long-term viability. They reveal if the company can sustain itself by paying off its long-term debts and interests on debts. Solvency ratios compare a company’s liability with its earnings, assets, and equity. Examples include debt-equity ratio, debt-asset ratio, and interest coverage ratio
3. Profitability Ratio
Profit margin, return on assets, return on equity, return on capital employed and gross margin ratios are profitability ratios that convey how profitable the company can be by carrying out its business operations.
4. Efficiency ratio
The efficiency ratio determines how effectively a company uses its resources to improve profits by increasing sales. Examples of efficiency ratios are turnover ratio, inventory turnover, and day sales in inventory.
5. Coverage Ratio
Coverage ratios determine the company’s ability to make interest payments and debts. Examples are the interest-earned ratio and debt-service coverage ratio.
6. Market Prospect Ratios
These ratios are used by investors to perform fundamental analyses of companies. They use these metrics to forecast earnings and future performance. The future stock prices and dividend earnings can be predicted using these ratios.
Uses of Ratio Analysis
Ratio Analysis helps companies to compare their performance with their competitors and established market standards. Various financial ratios obtained from the financial statements help the management identify gaps. They can do a SWOT (Strengths, Weaknesses, Opportunities, and Threats) and improve their operations.
The change in strategy and decision-making can improve the position and image in the market. Investors can use this information to understand how well their investments are performing.
2. Periodic trends
Trends can be found using the results of analysis over time. By collecting the numbers for many reporting periods, the management can know past, present, and future trends of the business performance. They can use these trends to forecast the future.
They can also use the trends to be prepared for unknown events and their impacts. The information so obtained cannot be gained by analyzing the immediate reports. Similarly, investors can use trend lines to make decisions about the short and long-term of their investments and returns.
Financial ratios are used to know the status of assets and liabilities of the company. The efficiency of the management in using the resources is known by analyzing the ratios. Inefficient use of assets and unnecessary expenses need to be eliminated as they directly affect the profitability of the company. The financial ratios reveal these facts and can aid the management in making changes in their operations and improving efficiency.