Financial ratio analysis is a ratio of a company’s data of items to check the financial status of the company. It is a quantitative tool by which companies can easily measure their company’s liquidity, profitability, efficiency, solvency, status, value, strength by analyzing the financial records such as balance sheet, income statement, and cash flow statement. It compares the company’s financial status with the other industry, company, and other sectors by calculating some financial ratios.
Everyone has their contribution to building a company whether it is financial investors, managers, advisors, marketing consultant, accountants, shareholders or stakeholders, employees.
- These contributors calculate the performance of the company with the help of ratio analysis.
- It is necessary to dilute the financial position of the company and to do a comparison with other business or financial sectors.
- It helps to evaluate the actual and accurate position of companies in the financial market.
- It helps companies to make financially valuable decisions.
- Some outside parties are always eligible for comparing financial health with other business competitors.
- These ratios help the company’s managers and financial investors to improve performance and make drastic changes in the company’s environment.
- It’s not that comparison of ratios is not the only meaning of financial ratios for a fixed time but also compare the same ratio with other or same industries.
Advantages of Financial Ratio Analysis
- Helps in achieving future goals: Financial ratio analysis tells managers and financial investors about the financial wealth of the company and provides a way how to make changes and increment in performance.
- Analyze financial performance: Financial Ratio analysis determines the company to analyze the financial position and describes where your company lies, from where the company needs improvement and so many things about the company’s improvement.
- Helps in making a budget: Financial Ratio analysis helps in making a new financial budget according to the ratio which is done to calculate the liquidity, revenue, profitability, sales, expenses.
- Helps in decision-making: Financial ratio analysis helps investors and managers in making decisions related to commercial purposes like current assets, liabilities, how to generate more revenue, more sales.
Types of Financial ratio analysis
There are some financial ratios under some categories from which companies can analyze their exact place in the financial market by calculating profit, sales, interest on the debt, inventory and so many things.
Liquidity ratio measures the fluidity of the company by using the formula’s of some ratios. These below ratios helps us to find out the property of flowing easily and determines that the assets are converting into cash or not.
Liquidity ratios consist of three ratios:
- Working capital ratio
- Quick ratio
- Cash ratio
These ratios tell the managers and investors that the company can meet its current debt with its current assets. With these ratios, managers calculate to meet its requirements.
Working capital ratio
- Working capital ratio is calculated as deducting liabilities from assets.
- It is taken out from the balance sheet.
- It analyses when a business can pay its short-term debts such as account payables, wages, or salary.
- It measures to find out the ability of a business.
- It is also known as the acid test ratio.
- This ratio describes how a company can handle instant sales in business and meet its short-term debts.
- It tells companies how to generate more revenue.
- Method to calculate this ratio: current assets – inventory/ current liabilities.
- It is calculated as cash and cash equivalents are divided by current liabilities.
- It describes how a company can manage its expenses or liabilities without selling any assets.
- It shows the ability of the company to pay all the liabilities.
Efficiency ratio measures the elasticity of a business by using the formula of some ratios. These below ratio has different formula to calculate competence of company with the other company in the same industry.
Efficiency ratios consist of 4 ratios:
- Inventory turnover ratio
- Days sales outstanding
- Fixed assets turnover ratio
- Total assets turnover ratio
Inventory turnover ratio
- Inventory turnover ratio describes the number of times the inventory is sold and resold during the year.
- With this, the manager can easily understand the available stock in the company and how much revenue can be easily generated.
- Method to calculate this ratio: sales/inventory.
Average collection period
- It describes the company how much sales is done and how much account receivables are taken from clients or customers.
- It is calculated as the average collection period/average sales per day.
Fixed assets turnover ratio
- This ratio describes how much a company uses fixed assets such as property, land and building, plant and machinery, equipment.
- It is calculated as sales/net fixed assets.
Total assets turnover ratio
- It describes how these total assets generate revenue and profit for the company.
- Method to calculate this ratio: sales/total assets.
Solvency ratio measures the company’s paying capacity against their long term debts such as bonds, debentures, convertible bonds.
It is also known as the debt management ratios and it consists of two ratios:
- Total debt ratio
- Debt-to-equity ratio
Total debt ratio
- It is calculated as total liabilities/total assets.
- It determines the fund of the company in percentage and measures of solvency.
- It is represented in the balance sheet as debt.
Debt to equity ratio
- It is calculated as total liabilities/total assets-total liabilities.
- It is the most valuable ratio to calculate if a business is traded commercially by investors for its financial purpose.
- It is known as the total debt ratio.
Coverage ratio measures the operating income from debts and determine the potential to obtain more cash to pay their debts. the This ratio includes all the cost such as interest expenses, lease payments incurred by the borrowers, and it consists of two ratios:
Interest earned ratio
- It refers to the number of times the company can earn interest on its debt with its earnings before interest and taxes.
- Method to calculate this ratio: EBIT/interest expense.
Debt service coverage ratio
- Method to calculate this ratio: net operating income/total debt service charges.
- It tells how a company can manage and pay all the debt.
Profitability ratio measures the company’s capacity to earn a profit from sales, equity stakeholders, assets and generate revenue by summarize the financial statements.
It consists of three ratios:
Net profit margin
- Method to calculate this ratio: net income/sales.
- It is one of the best methods to show a profit on sales.
Return on total assets
- It is calculated as net income/sales.
- It shows how to generate a profit on total assets.
Return on equity
- It is calculated as net income/equity.
- It shows how much money shareholders earn from their investments in the company.