What is Ratio Analysis?
Ratio analysis is a quantitative analysis done to ascertain the financial performance of a company. It provides detailed insight into the company’s profitability, operational efficiency, liquidity, debt, market solvency, and other crucial aspects.
The analysis is mainly employed by external analysts for determining the well-being of a company by studying its balance sheet and other associated financial statements. This tool is less useful to corporate insiders who have better access to detailed operational information about their organization.
Ratio analysis is extremely beneficial when used in the following two ways.
- Trend Line: The Trend Line indicates the financial difficulties a company is facing and to evaluate the direction of future ratio performance.
- Industry Performance: This comparison approach is utilized for sector analysis to determine which businesses within a particular market sector are the least and the most valuable.
- Performing ratio analysis is crucial for analyzing the financial position, efficiency, solvency, risk, profitability, funds utilization, and operations effectiveness of an organization.
- Ratio Analysis is a helpful tool for decision making for shareholders of the company.
- Ratio Analysis helps in the interpretation of financial statements of companies and offers valuable insights to compare the performance trends of two or more companies over a period of time.
Objectives of Ratio Analysis:
Performing ratio analysis of the company helps in the interpretation of numbers from income statements and balance sheets. Each stakeholder in a company has a different interest when it comes to the result. For instance, equity investors are more focused on the growth of dividend payments and the earning power of an organization in the long run. Creditors just want to ensure that they are getting their repayment dues on time.
Here are the major benefits of ratio analysis.
One of the main uses of ratio analysis is to compare a company’s performance to similar firms functioning with the industry to study its position in the market. Procuring financial ratios of competitors and comparing it with their company’s ratios can help the management identify the market gap and examine its strengths, competitive advantages, and weaknesses. This information can be used to formulate decisions that aim to improve the company’s position in the market.
Companies can use ratios to check the trend of performance. Established companies can perform data collection of financial statements over a specific number of reporting periods. The trend obtained can help predict the direction of future financial information and can also help in the identification of any financial turbulence which would not be possible with a single reporting period.
The management of a company can employ financial ratio analysis for determining the degree of efficiency in the management of assets and liabilities. Inefficient use of assets such as buildings, land, motor vehicles, and others can be eliminated. Financial ratios also help in determining if the financial resources are over or under-utilized.
Different types of ratio analysis:
Numerous financial ratios can be used for different types of ratio analysis. Here are some of the most popular methods.
Liquidity ratios are a measure of the ability of a company to meet its debt obligation using the current assets. Whenever a company is facing a financial crisis and is unable to repay its debts, it can convert its assets into cash and utilize the money to settle any pending debts with much more. Banks, suppliers, and creditors use liquidity ratios to determine if their client has the ability to honor their loan agreement.
Solvency ratios measure the financial viability of a company in the long term. These compare the debt levels of a company to its annual earnings, equity, or assets. Important solvent ratios include equity multiplier, interest coverage ratio, debt ratio, and capital ratio. Solvency ratios are mainly employed by institutional investors, employees, banks, and the government.
Profitability ratios measure the ability of a business to earn profits relative to its associated expenses. A higher profitability ratio than the previous financial reporting period indicates that a business is thriving financially. This ratio can be used to compare to a similar firm’s ratio to study how profitable the business is relative to its competitors. Some examples of profitability ratios include gross margin, return on assets, profit margin, and return on equity ratio.
Efficiency ratios are indicators of the current and short-term performance of an organization. Analysts screen the financial statements of a company such as income statements and balance sheets to aggregate numbers for financial calculations. Efficiency ratios can be compared with peer companies to gain an insight into how the company is performing relative to its competitors.
Market prospect ratio:
These ratios help investors in determining the future profitability of an investment. They include earnings per share, P/E ratio, dividend payout ratio, and dividend yield. For instance, if the average P/E ratio of all companies is 20 in the S&P 500 index and if the majority of companies have their ratio between 15 and 25, then a stock with a P/E ratio of eight would be considered undervalued.
Also, a stock with a P/E ratio of 50 would be treated as overvalued. The former stock with a low P/E ratio may trend upwards in the future while the latter may take a downwards trend.
How can company management use ratio analysis?
Ratio analysis can be a great tool for companies for benchmarking their performances against their best. If your competitors are performing well, you can analyze their financial statements to gain a basic idea of the areas where you are lacking. This will help you point to your weak areas and improve.
Calculation of ratio analysis can be used for both inter and intra-company comparisons. It can be used to compare the performance of various departments within the company and can be utilized by the management to find out which departments are pulling the overall performance.
Ratio analysis forms the foundation for financial analysis to achieve an in-depth insight into the performance of a company. This quantitative method helps external analysts in gauging the financial performance on a yearly basis concerning the crucial components. You can scrutinize the past and correct the course for the future leveraging ratio analysis. The ratio analysis report offers a comprehensive view of a company from various angles so that you can verify the merits of your investment moves.