What is ratio analysis?
In terms of financial analysis, ratio analysis is used to evaluate a company's financial performance in areas such as profitability, liquidity, efficiency, and solvency. For example, by using ratios such as the debt-to-equity ratio or total asset turnover ratio, investors can gain insight into how well a company is managing its financial resources and what kind of return it may be able to achieve on its investments.
Different types of Ratio analysis
- Liquidity Ratios: These ratios are used to assess an organization's ability to pay its bills promptly and keep its debt commitments. They measure the company's access to liquid resources such as cash, marketable securities, and accounts receivable. Common liquidity ratios include the current ratio, quick ratio, cash ratio, and working capital ratio.
- Solvency Ratios: These ratios measure a company’s ability to meet long-term financial obligations and sustain its business operations over a long period. The focus of these ratios is on the balance sheet rather than income statement like liquidity ratios. Examples of solvency ratios are debt-to-assets ratio, debt-to-equity ratio, and interest coverage ratio.
- Profitability Ratios: These ratios involve the analysis of income statements or profit & loss accounts to determine how efficient a firm is in managing its resources and assets for generating profits. Examples of profitability ratios include gross margin ratio, operating margin ratio, return on assets (ROA) and return on equity (ROE).
- Efficiency Ratios: These ratios measure how effectively a company utilizes its assets to generate revenues and sales. Efficiency ratios can provide insight into whether a company has too much inventory or too much debt relative to sales. Examples include inventory turnover ratio, asset turnover ratio, and, days sales outstanding (DSO).
- Coverage Ratios: These are also known as debt service coverage ratios, which measure a company's ability to pay down debts using earnings from operations. Coverage ratios help creditors determine whether an entity will be able to make scheduled payments on time without defaulting on its loans or other financial instruments. Examples include the fixed charge coverage ratio, interest coverage ratio, and dividend payout coverage ratio.
Advantages of Ratio Analysis
This form of comparative analysis is useful for making decisions such as whether or not to invest in a company, the financial health of a business, the liquidity of its assets, and the overall performance of an organization. Ratios are also useful in benchmarking how well an organization’s performance compares with other companies in the same industry or sector.
The advantages of ratio analysis include that it provides a basis for comparison between different companies over time, as well as facilitating comparison between similar organizations operating in different industries. It can provide insight into the operational efficiency and effectiveness of management, by analyzing ratios that measure profitability and leverage. It can also provide information on liquidity risk, debt burden, and cash flow situation. In addition to providing data for making short-term decisions such as whether to invest or not, ratios can also be used to assess long-term investment opportunities.