Ratio Analysis - Meaning, Types, Methods and Limitations (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 a financial tool used to evaluate a company’s performance by examining key financial ratios related to profitability, liquidity, solvency, and efficiency. It helps stakeholders understand the company’s financial health by analysing data from its balance sheet, income statement, and cash flow statement.

Ratio analysis is important because it provides insights into a company’s ability to generate profits, meet its short-term and long-term obligations, and operate efficiently. By comparing ratios over time or against industry standards, businesses can make informed decisions. The ratio analysis formula is calculated by dividing the first number in the ratio by the second number. The result is typically represented as a decimal or, in some cases, multiplied by 100 and expressed as a percentage.

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 advantages of ratio analysis?

• Ratio analysis helps you see how well a company is using its resources to generate profits.
• It provides valuable information about the financial health and performance of a business to its stakeholders.
• It allows you to compare the financial performance of different companies. This comparison helps you to understand a company’s relative strengths and weaknesses.

It helps assess a company's ability to meet short-term obligations (liquidity) and long-term financial stability (solvency).

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

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• What is cash ratio
• What is Treynor ratio
• What is quick ratio
• What is financial ratio analysis
• What is expense 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:

• (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

Importance and uses of ratio analysis

Ratio analysis is a vital tool used to evaluate and interpret a company's financial health, efficiency, and performance. It helps in making informed decisions by providing a clearer understanding of various financial aspects. Below are some key uses and the importance of ratio analysis in assessing a company's financial stability and operational efficiency.

1. Analysis of financial statements

Ratio analysis helps in breaking down complex financial statements into simpler ratios, making it easier to understand a company's performance. It provides insights into the balance sheet, income statement, and cash flow, helping investors, stakeholders, and management assess the overall financial position of the firm.

2. Helps in understanding the profitability of the company

Profitability ratios like gross profit margin, net profit margin, and return on equity provide valuable insights into how well a company generates profit relative to its sales, assets, and shareholders' equity. It allows businesses to gauge their profitability and identify areas for improvement.

3. Analysis of operational efficiency of the firms

Operational efficiency ratios such as inventory turnover and asset turnover measure how effectively a company is using its resources to generate revenue. This helps firms pinpoint inefficiencies in operations and streamline processes for better productivity.

4. Liquidity of the firms

Liquidity ratios, such as the current ratio and quick ratio, measure a firm's ability to meet short-term obligations. This analysis ensures that the company maintains enough liquidity to cover immediate liabilities, protecting it from potential financial crises.

5. Helps in identifying the business risks of the firm

Business risk is linked to the volatility in a company's operational performance. Ratio analysis helps identify such risks by analysing operating leverage and variability in earnings. This assists firms in mitigating risks and stabilising their performance.

6. Helps in identifying the financial risks of the company

Financial risk is associated with a firm's capital structure and debt levels. Debt-to-equity and interest coverage ratios provide insights into how much risk the company is taking by using debt to finance its operations. Ratio analysis aids in maintaining a balanced financial risk profile.

7. For planning and future forecasting of the firm

Ratio analysis is not just a tool for assessing the present but also for planning future business strategies. By analyzing historical financial ratios, companies can predict future trends, helping in setting realistic goals and preparing for market fluctuations.

8. To compare the performance of the firms

Comparing financial ratios between firms within the same industry allows for benchmarking. It helps in identifying competitive advantages or areas where a company may be lagging behind, enabling better strategic decisions to enhance performance.

Application of ratio analysis

When you use ratio analysis, you get various figures to compare. However, these numbers alone aren't very useful. You need to compare these figures with other data, like industry averages or past performance. This helps you see if the company is financially strong, weak, getting better, or getting worse. Such a comparison can be made in three ways, representing the practical application of ratio analysis.

1. Ratio analysis over time

By tracking changes in specific ratios over time, you can see how a company has been performing during that period. Often such an observation reveals potential risks and shows what growth trends the company might follow.

To do this, pick one financial ratio and calculate it at regular intervals (like every quarter). Then, look at how this ratio changes over time. Lay special focus on checking:

• Is the ratio improving?
• How fast is the ratio changing?
• Whether the changes in ratio align with the company’s goals?

While comparing, always remember that some changes might be temporary or due to seasonal factors. Hence, be careful when comparing monthly ratios because these fluctuations can affect the analysis.

2. Ratio analysis across companies

By comparing a company's ratios to those of similar companies in the same industry, you can see how well it's performing. For example, a company with a 10% gross profit margin might be doing well if the average of its competitors is 5%. However, if the average of its competitors is 25%, the company may be struggling.

To make a meaningful comparison, the following key considerations must be followed when comparing ratios between companies:

• Only compare companies within the same industry.
• Be aware that different capital structures (how they finance operations) and sizes affect efficiency.
• Consider differences in product lines (e.g., one company sells physical products while another offers similar services).
• Remember that different industries have different expectations. For example, a high debt-equity ratio might be normal for a utility company but too high for a tech company.

3. Ratio analysis against benchmarks

It is worth mentioning that companies often set internal targets or specific goals for their financial ratios. These goals are majorly set to maintain current levels or to achieve growth. For example, if a company has a current ratio of 1.1 and wants to improve its liquidity, it might set a target to reach a current ratio of 1.2 by the end of the year.

External parties, like lenders, also set benchmarks for companies. These benchmarks are requirements for maintaining certain financial health levels. For example, a lender might require a company to maintain a specific debt service coverage ratio (this ratio compares the company’s cash flow to its debt). Now, if the company fails to meet these benchmarks, the lender might demand repayment of the loan or increase the interest rate.

What are the disadvantages of ratio analysis?

• Sometimes, financial statements are complex and can be difficult to understand. Such complexity makes ratio analysis challenging.
• Comparing companies from different industries can be misleading because they operate under different market conditions and regulations.
• It must be noted that financial data is influenced by various opinions and assumptions. Applying different accounting methods usually makes comparisons less accurate and reduces the usefulness of ratio analysis.
• Ratio analysis mainly looks at past data, while users are more interested in current and future information.

Key takeaways

• Ratio analysis helps you compare different figures from a company's financial statements to see how well it’s doing in terms of profit, liquidity, efficiency, and financial stability.
• You can use ratio analysis to see how a company’s performance changes over time or to compare it with other similar companies.
• Sometimes, external parties like lenders use ratio analysis to set benchmarks and assess risk.
• Ratios are helpful, but to obtain a complete view of a company’s financial health, they should be used alongside other financial metrics.
• Some common examples of ratios you can analyse are the current ratio (liquidity), gross profit margin ratio (profitability), and inventory turnover ratio (efficiency).

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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