Home»Blog»Business»What is Financial Ratio Analysis? – Know the Types, Advantages and Disadvantages
What is Financial Ratio Analysis? – Know the Types, Advantages and Disadvantages
31 October 2022
Ratio analysis is a process that enables people to assess an organisation’s financial health. The analysts learn about the profitability potential of an organisation and its operational efficiency using this process. It also offers information about the liquidity of the assets and whether they are enough to meet the company’s working capital requirements.
The ratio analysis results are also an efficient indicator of a company’s performance relative to its competitors, and thus, its ability to compete with them.
This article will help you understand what ratio analysis means, its advantages and disadvantages, and the types of ratio analysis.
What is Ratio Analysis?
The ratio analysis of a company involves studying and comparing the data from its financial statements. The data is actively used to determine the company’s financial well-being and eliminates the need to individually analyse each and every line item in the financial statement.
This enables the investors and management to assess the organisation’s growth rate. It could also help in identifying any operational drawbacks. The management can, thus, devise a plan for financial action using the ratio analysis.
For instance, if a company’s revenue is Rs.10,00,000 and operational costs are Rs.5,00,000. This means the gross profit is Rs.5,00,000. Thus, according to the ratio analysis, the profit is 50% of the company’s revenue.
The resultant profit margin is expressed as a percentage, not a line comparison based on financial statements. This is just one application of ratio analysis. Companies perform several types of ratio analysis to evaluate their financial operations. Understanding the types is a great way to know the advantages and limitations of ratio analysis (more on this later).
Objectives of Ratio Analysis
Ratio analysis of financial statements benefits all stakeholders in an organisation. It enables comprehensive financial analysis and effective financial management. Here are some objectives of ratio analysis:
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.
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.
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.
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.
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.
Companies use ratio analysis to compare their financial state to other companies’ and their own financial performance in the past. The data that ratio analysis generates needs to be compared to other organisational data to better understand business trends and the company’s industry standing. Below are the uses of ratio analysis:
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.
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.
Types of Ratio Analysis
The following types of ratio analysis help a company to understand its financial condition and position in the industry. They do it by determining asset liquidity, profitability, cash flow, solvency, etc.
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 fulfil its long-term financial obligations, such as loan repayments or bonds issued in secondary markets.
Ratio Analysis Examples
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%.
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.
What are the Steps of Ratio Analysis?
The major steps involved in the ratio analysis of financial statements include the following:
Deriving accounting data from statements
Finding ratios using formulas
Comparing the ratios with standard ratios such as ratios from the past, ratios of competitors, average ratios of the industry, etc.
Interpreting the results to devise the future course of action
Advantages of Ratio Analysis
Ratio analysis offers several advantages. Below are the most prominent ones:
Ratio analysis governs the operational decisions of the organisation. It helps to formulate or scrap managerial policies based on the percentage value. Since ratio analysis converts complex financial statements to simple ratios and percentages, organisations can make quick decisions to improve their financial standing.
Ratio analysis also facilitates better decision-making by offering a bird’s-eye view of the strengths and shortcomings of operations. The analysis also indicates how the organisation is growing, and thus, helps with managerial decisions.
It also enables the comparison of an organisation’s performance with other players in the industry. This helps to understand how the company is positioned in the sector.
Disadvantages of Ratio Analysis
In addition to the advantages, ratio analysis has certain limitations too. The notable disadvantages are below:
Ratio analysis just offers information that can be interpreted to make decisions. It is not the solution but just a process to reach the solution.
Companies adopt varying methods of ratio analysis and there is no uniformity. This may lead to incompatible data that is difficult to analyse and draw an effective comparison to reach a conclusion.
It only yields information about the financial standing of a company and says nothing about the qualitative aspects such as productivity or working conditions.
It can be used only for companies of the same size and type.
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.
Q1. What is ratio analysis?
Ans. 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.
Q2. What is the purpose of ratio analysis?
Ans. 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.
Q3. How does ratio analysis help with decision-making?
Ans. 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.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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