Ratio analysis is a key method in financial analysis that evaluates a company’s performance and financial health. By analyzing numerous financial parameters, investors, analysts, and managers can acquire insight into profitability, liquidity, efficiency, and solvency. Here are the main types of ratio analysis:
1. Liquidity Ratios
Purpose: Evaluate a company’s ability to fulfill its short-term obligations.
- Current Ratio: current assets divided by current liabilities. A ratio greater than one shows that the corporation can meet its short-term liabilities with its short-term assets.
- Quick Ratio = (Current Assets – Inventories) / Current Liabilities. This ratio excludes inventory, resulting in a more rigorous estimate of liquidity.
2. Profitability Ratios
Purpose: Determine a company’s profitability in relation to its sales, assets, or equity.
- Gross Profit Margin = (Gross Profit / Revenue) x 100. Determines the percentage of income that exceeds the cost of products sold.
- Net Profit Margin = (Net Profit / Revenue) x 100. Reflects the overall profit after all expenses.
- Return on Assets (ROA) = Net Profit / Total Assets. Demonstrates how effectively a corporation uses its assets to produce profits.
- Return on Equity (ROE) = Net Profit / Shareholder Equity. Measures the return on shareholders’ investments.
3. Leverage Ratios
Purpose: Determine a company’s level of financial leverage and ability to meet long-term obligations.
- Debt to Equity Ratio = Total Debt / Total Equity. Indicates the proportion of debt utilized to finance the company’s assets in comparison to equity.
- Interest Coverage Ratio = EBIT / Interest Expenses. This demonstrates how easily a corporation may pay interest on its outstanding debt.
4. Effective Ratios
Purpose: Determine how effectively a corporation uses its assets and runs its operations.
- Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory. Indicates how frequently merchandise is sold and replenished over time.
- Accounts Receivable Turnover Ratio = Net Credit Sales/Average Accounts Receivable. Determines how successfully a corporation collects receivables.
- Asset Turnover Ratio = Revenue / Total Assets. Reflects how well the organization uses its assets to create sales.
5. Market Ratios
Purpose: Provide information about the company’s market performance and investor perspectives.
- Earnings Per Share (EPS) = (Net Income – Dividends on Preferred Stock) / Average Outstanding Shares. The percentage of a company’s profits allocated to each outstanding share of common stock.
- Price to Earnings Ratio (P/E) = Market Price per Share / Earnings per Share. Indicates how much investors are ready to pay each dollar of earnings.
Conclusion:
Ratio analysis is essential for assessing many aspects of a company’s performance and financial health. Stakeholders can make informed investment, financing, and management decisions by reviewing liquidity, profitability, leverage, efficiency, and market ratios. Each ratio provides distinct insights, and when combined, they provide a complete picture of the company’s overall financial health.
