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What is Ratio Analysis?

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Ratio analysis is a category of analysis that helps us examine the financial statements (e.g., balance sheet and profit & loss account) of a company. It is usually based on two line items reported in financial statements. For example, net margin is arrived at by dividing a company's net profit by its sales. So, the two line items here are net profit and sales.

Ratio analysis helps us analyse a company's profitability, solvency, liquidity, and many other aspects. When we compare the ratios of one company with its close competitors, it helps us draw compelling insights. Having learnt what ratio analysis or its meaning is, let us delve deeper into this topic.

How Ratio Analysis Works

Ratio analysis works by considering data reported by a company in its current and past financial statements. After you calculate the relevant ratios of a company, you need to draw a comparison.

First, you should compare a company’s ratios based on its current data with those based on its past data. This will help you understand whether a company is improving its performance on a certain parameter. Then, you should compare a company’s ratios with those of its closest rivals to understand how it is faring in its industry.

In isolation, ratios rarely ever make any sense. Hence, comparisons are extremely important here. Let us say that a company’s net margin has improved to 12% this year from 8% in the previous year. In this case, you should analyse the reasons behind the improvement.

You must also compare the net margin of this company for this year and previous years with that of its competitors, as that will provide you with a holistic view of its performance.

Limitations of Ratio Analysis

Ratio analysis is based on either current or past data of a company. This data may or may not help you estimate a company’s performance in the future. Hence, you should not rely only on ratio analysis.

At times, companies change their accounting policies, which have a significant impact on their financial statements. Sometimes due to such changes, their financial statements may not be comparable with the last year. In such a case, ratio analysis cannot help you much.

A company may significantly change the nature of its business. Let us say that a footwear manufacturer decides to launch a premium range, which has a higher margin than its existing products. In this case, its margin of this year may not be comparable with that of the previous year.

Types of Ratio Analysis

Ratio analysis is used to analyse several aspects of a business. The most important types of ratio analysis are explained below:

  • Profitability ratios: These ratios analyse a business’s ability to generate profits from the investments it has made in its assets and from the expenses it has incurred on its operations. Some of the most popular profitability ratios are net profit margin, gross margin, return on assets, return on capital employed, and return on equity ratio.

  • Liquidity ratios: These ratios analyse how comfortably a company can pay its short-term debt or obligations using its current assets. If a company is unable to meet its short-term obligations, it may face a liquidity crunch, which can affect its operations. Common liquidity ratios include current ratio and quick ratio.

  • Solvency ratios: These ratios examine a business’s ability to meet its long-term obligations. In other words, these ratios analyse whether a business can remain solvent. Common solvency ratios include interest coverage ratio,debt to capital ratio, and debt ratio.

  • Efficiency ratios: These ratios examine whether a business is able to use its assets and liabilities in an efficient manner to generate revenue and profit. Famous efficiency ratios include inventory turnover, payables turnover, asset turnover, fixed asset turnover, working capital turnover, etc.

  • Coverage ratios: These ratios check whether an enterprise can pay all the expenses and other obligations associated with its debt or not. Important coverage ratios are interest coverage ratio, debt coverage ratio, and EBITDA coverage.

Examples of Ratio Analysis

It is better to understand ratio analysis with some examples. We can draw interesting insights by correlating a company’s performance on one ratio with that on another ratio. Suppose a company “X” launches a premium product, which is available at a higher price than its other products. Obviously, its gross and net margin will improve.

However, as premium products are expensive, customers are not able to pay for them easily. Hence, the company is extending them credit, which is affecting its working capital turnover ratio because its investments in its working capital have increased.

Let us take another example. Suppose a company “Y” recently faced a liquidity crunch. Hence, it decides to keep a significant amount of cash so that it never faces a liquidity issue. However, this cash is idle, as it is not invested into the business. Hence, the company will not generate any return on it. Therefore, its return on assets (RoA) will decline.

Why is Ratio Analysis Important?

Ratio analysis is important for multiple reasons. First, it helps us interpret complex financial data reported in statements like balance sheets and profit & loss accounts. Without ratios, the numbers reported in these statements do not reveal much. Second, as ratio analysis is based on numbers, it is quantitative in nature and hence more concrete than a qualitative assessment of a company, which is subjective. Third, when the ratios of a company are compared with those of its competitors, it helps us analyse whether it is under or overperforming.

Conclusion

Ratio analysis is extremely important for investors. We can use ratios to perform a trend analysis to ascertain whether a company has improved its operations in recent years or not. Besides, we can compare a company’s ratios with those of its rivals to check whether it is worth investing. While it may not take much to learn the formulas for ratios, it takes time and experience to know when to apply which ratio. That said, with effort and dedication, you can become adept at using ratio analysis.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing. This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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Frequently Asked Questions

What is the meaning of ratio analysis?

Answer Field

It is that kind of analysis that is based on the data reported in the financial statements of a company. To calculate a ratio, we typically need two line items or numbers reported in a financial statement, like a balance sheet or profit & loss account.

Why is ratio analysis important in financial management?

Answer Field

Ratio analysis helps us examine a company’s performance on several parameters, like profitability, liquidity, solvency, efficiency, etc. Simply put, ratio analysis helps us understand whether a business is being run well or not.

What are the different types of ratios used in ratio analysis?

Answer Field

Profitability ratios, liquidity ratios, solvency ratios, coverage ratios, and efficiency ratios are some prominent types of ratios.

How do you calculate common financial ratios?

Answer Field

First, we need to get the relevant data from a company’s financial statements. Then, we need to input that data into a formula to calculate a ratio.

What are the limitations of ratio analysis?

Answer Field

Ratio analysis is based on past data. Hence, it is not necessary that it will help us predict a company’s future well. When a company changes its accounting policies, its ratios may not remain comparable across different financial years.

How can ratio analysis help in investment decisions?

Answer Field

Ratio analysis can help us examine whether a company is performing well compared to its competitors. Then, stock market ratios like price-to-earnings (P/E) ratio tell us whether a company’s performance is accurately represented in its price. Based on ratios, we can decide whether to invest in a company.

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