What is Financial Ratio Analysis? – Objectives, Types and Uses
Ratio analysis is a process that allows people to assess the financial health of a company. Using this process, analysts learn about an organization’s profitability potential and operational efficiency. It also provides information on the assets’ liquidity and whether they are sufficient to meet the company’s working capital requirements. The results of a ratio analysis are also an effective indicator of a company’s performance in comparison to its competitors, and thus its ability to compete with them.
This blog will help you understand why ratio analysis must be undertaken and the various ways to do so. Let’s dive in!
Ratio Analysis Examples
1. Profitability Ratio
Below is the formula for net profit margin
(Net Profits / Net Sales) x 100 = Net Profit Margin
Suppose a company has a turnover of Rs.10,000 and a net profit of Rs.2,000, the net profit margin is 20%.
2. Liquidity Ratio
The current ratio is a common liquidity ratio. It determines whether a company can pay off current liabilities using current assets. A high current ratio indicates that the company can easily clear current liabilities with current assets.
Here is the formula for the current ratio:
Current Ratio = Current Assets / Current Liabilities
Suppose a company has current assets worth Rs.100 and current liabilities worth Rs.40. The current ratio, in this case, will be 2.5. This indicates that the company has assets worth Rs.2.5 per dollar of current liabilities.
Objectives of Ratio Analysis
1. To Measure Profitability
The objective of any business is profitability. Ratio analysis helps to measure values like gross profit ratio, net profit ratio, expense ratio etc., to understand if a business is yielding enough profits or not. A thorough understanding will enable the management to identify problem areas and work on them.
2. To Assess Operational Efficiency
Some ratios are used to assess how efficiently a company manages its resources and assets. Efficient use of assets and resources is critical for avoiding meaningless expenses. Mismanagement of assets can be measured using turnover ratios and efficiency ratios.
3. To Ensure Easy Cash Availability
A company may need cash any time, and it has to ensure that some assets can be liquidated quickly to make up for the requirement. The quick and current ratios of the company determine a firm’s liquidity. Maintaining these ratios at an optimum level ensures the organisation has adequate liquidity.
4. To Determine the Financial Health of the Organisation
Ratio analysis of a company can also help to determine its long-term solvency. These ratios include debt-equity ratio, leverage ratio. etc. and help the management to assess the situation and take steps to avoid liquidation. They indicate if there is a strain on the assets or if there is enough leverage in case of a financial crisis.
5. To Compare the Performance
Knowing the fiscal position and financial well-being of the company is important to understand the company’s performance. It also helps to determine the actions management needs to take to improve performance. The ratios are compared to industry standards and previous years’ ratios to assess the progress.
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Types of Ratio Analysis
1. Activity Ratio Analysis
A company’s efficiency and scale of operations can be determined using activity ratio analysis. Using the result of activity ratio analysis, management can determine the pace at which the inventory is being converted to sales. It also helps to understand how the returns from the sales are used to manage fixed and working capital requirements. Other ratios in this analysis include payables turnover ratio, inventory turnover ratio, working capital turnover ratio, etc.
2. Profitability Ratio Analysis
This ratio analysis enables a business to measure its gains. It also helps accountants to see which companies have generated the most profits. These metrics could be used to evaluate a business’s ability to generate earnings in comparison to its revenue, operating costs, balance sheet assets, or shareholders’ equity over time.
3. Liquidity Ratio Analysis
Organisations use this analysis method to understand how fast they can convert their assets to cash. This way, they will know if they can make up for their financial requirements without roadblocks.
4. Solvency Ratio Analysis
This analysis is an indicator of the financial sustainability of the business in the long run. Using this analysis, the organisation can assess whether they have enough to fulfill its long-term financial obligations, such as loan repayments or bonds issued in secondary markets.
Use of Ratio Analysis
1. Understanding Business Trends
Ratios calculated over varying reporting periods and compared with past ratios can help in understanding whether the company is moving upward or downward. They also indicate whether the company is clearing its debts or accumulating more.
2. Competitive Comparison
Companies also use ratio analysis to compare their business to others in the same industry. This is because other businesses have similar assets and capital structure. Comparisons of ratios can help the companies to find if they are industry leaders or maintain pace with competitors.
Advantages of Ratio Analysis
Ratio analysis offers several advantages. Below are the most prominent ones:
- Ratio analysis helps analysts undertake technical analysis and forecasting trends.
- It helps in creating budgets based on the usage of funds and relevant outputs in the previous years.
- It helps in presenting accounting information to various stakeholders in a manner that makes interpretation of results easier.
- It helps in undertaking a comparative analysis with different firms of the same sector or with past performance.
- It helps in determining the liquidity position of the firm as well as its solvency.
- It helps in analysing turnover rates and estimating inventory requirements.
- It determines the operational efficiency of a business and helps in taking controlling decisions.
Disadvantages of Ratio Analysis
In addition to the advantages, ratio analysis has certain limitations too. The notable disadvantages are below:
- It does not allow inter-sectoral comparison as the standards for every ratio may differ across various industries.
- It requires picking information based on complicated financial statements.
- It is based on historical data and gives an analysis of what has already happened. Whereas, the stakeholders are mostly interested in current data and future trends.
- It may be biased, depending on the technique used, and is prone to human error of calculation and differences in interpretation.
Final Word
Ratio analysis is an important indicator of a company’s success and performance. Understanding the meaning of ratio analysis and its calculations can help to assess a company’s performance, its positioning in the industry, and its growth trajectory, among other things. It is also an important decision-making tool that can aid managerial decisions.
A mutual funds expense ratio determines whether an investor should invest in a fund or not. Make wise investment decisions and begin investing today! Download the Navi App and get started now!
FAQs
Ratio analysis involves assessing data in financial statements and expressing it as ratios or percentages. This eliminates the need to go through financial statements line by line and offers an insight into the company’s financial health.
Ratio analysis helps assess the company’s financial health based on certain parameters. It helps to evaluate the company’s performance, the efficiency of its operations, the availability of cash and liquidity, among other things.
Ratio analysis helps to compare a company’s performance with its records and the performance of other companies in the same industry. These comparisons could help in identifying the gaps and opportunities for change. The management can decide the course of action based on the parameters they wish to improve or introduce.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
