written by | January 9, 2023

Everything about Ratio Analysis | Meaning, Types and Uses

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Table of Content


Ratio analysis meaning refers to the analysis of underlying accounting information embodied in the financial statement. A financial ratio is a difference in magnitude between two specific numbers values from the financial accounts of an organisation. Ratio analysis can help investors, analysts, and management to understand a company's financial strengths and weaknesses, and to make informed decisions about the company's financial health.

Ratios can be used by businesses to check for trends in their financial performance. Established businesses gather information from financial statements across many reporting periods. In addition, ratio analysis is a financial analysis technique that involves calculating and comparing ratios derived from a company's financial statements. It is used to evaluate a company's financial performance, financial position, and liquidity. 

Did You Know? Through, Ratio Analysis, one can ascertain the solvency position of a company

What is Ratio Analysis?

Ratio analysis is a mathematical technique for analyzing a company's financial documents, such as the balance sheet and income statement, to gather knowledge about its liquidity, operational effectiveness, and profitability. Fundamental equity research is built on ratio analysis.

To gather information to assess a company's financial performance, analysts rely on current and historical financial statements. They make comparisons to other competitive companies and utilise the data to determine whether a company's financial health is trending upward or downward.

Also Read: What does the word Impairment in Accounting mean?

What is the interpretation of Ratio Analysis?

By carefully examining both historical and current financial statements, investors and analysts use ratio analysis to assess a company's financial health. Comparative data may show how a business is doing over time and be used to predict how it will likely do in the future. This information can be used to assess how a company compares to others in its industry and to benchmark its financial performance against industry averages.

Financial ratio analysis is another tool that a company's management can use to gauge how well assets and liabilities are managed. Ineffective use of resources like machinery, property, and buildings leads to excessive costs that need to be cut. Financial ratios can also be used to assess whether financial resources are being used too much or too little.

Various Kinds of Financial Ratios

There are numerous financial ratios that are used to assess different aspects of an entity like Solvency, Operation effectiveness, Cash management, etc. Here are some main types of Financial Ratios -

Efficiency Ratios

Efficiency ratios gauge how effectively a company uses its assets and liabilities to drive revenue and make a profit. They compute the turnover of liabilities, the use of inventories, the use of machinery, and the use of equity. These ratios are crucial because rising efficiency ratios increase a company's potential to increase revenues and profits.

Also Read: Goods in Transit (Meaning, Examples) and Accounting Treatment

Profitability Ratios

Profitability ratios demonstrate how effectively a business can turn a profit from its operations. Examples of profitability ratios include profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios. Profitability ratios gauge a company's capacity to turn a profit in relation to the costs that go along with it. A higher profitability ratio than in the last financial reporting period indicates that the company's financial situation is getting better. To evaluate how profitable a company is in comparison to its rivals, a profitability ratio can also be compared to the ratio of other similar companies in the same industry.

Debt Coverage Ratio

The ratio of operational revenue available for debt servicing for interest, principal, and lease payments is called the debt service coverage ratio (DCR). It is a widely used yardstick for evaluating how well-equipped a person or business is to generate enough cash flow to pay off its debt obligations. The easier it is to get a loan, the greater this ratio is. The expression can be used to represent a minimal ratio that is acceptable to a lender or a loan requirement in commercial banking. In some situations, breaking a DCR qualifies as a default.

Liquidity Ratio

The ability of a business to use its current assets to extinguish or retire its current liabilities is measured by the Liquidity ratios. In finance, It is described as the proportion of current liabilities to current assets. Liquidity ratios can be of two types, Current ratio, and quick or acid test ratio.

Solvency Ratio

Prospective business lenders frequently utilise a solvency ratio as a significant indicator of a company's capacity to repay its long-term debt. A company's financial health can be assessed by looking at its solvency ratio, which determines if its cash flow is sufficient to cover its long-term obligations. An unfavourable ratio can suggest a chance that a corporation would fail to pay its debts.

Share Price ratios

These ratios are the ones that fundamental analyst uses the most frequently. These metrics include the dividend yield, Price to earning ratio and Earning Per Share. These metrics are used by investors to forecast earnings and future performance.

Also Read: Cost Accounting vs Management Accounting

Cash Ratio Analysis

Only cash and cash equivalents are taken into account in the Cash Coverage Ratio, these are the most liquid assets within the Current Assets. A corporation is more likely to be able to meet its short-term obligations if it has a greater cash ratio.

Uses of Ratio Analysis

Ratio analysis is used to access the financial health of an entity and how well it is managing its operation and finances. The analyst uses ratios to ascertain the worth of the company and the intrinsic value of the shares. Here are a few usages of ratio analysis - 

Performance over time

Ratio analysis is a useful tool that a business can use to better understand its trajectory through time. The corporation is more interested in this type of study because it gives them information about how the company has done over time, whether strategies have worked, and what risks still exist in the future rather than being focused on where it is right now. Making strategic plans and long-term decisions sometimes involve performing ratio analysis.

Benchmark Review

External parties like lenders frequently implement benchmarks to access the financial position of the company. Lending institutions frequently have standards for sound financial standing. The standards may include agreed current and quick ratios. If these requirements are not met, the entire loan may be called, or a corporation may be required to pay an increased interest rate to offset the risk. The debt service coverage ratio, which compares a company's cash flow to its debt amounts, is an example of a benchmark set by a lender.

Conclusion

Ratio analysis is used by the different stakeholders of an entity to assess the risk involved in the business, solvency, profitability, operating efficiency, asset utilisation, etc. Management may on the other hand be more interested in their strategy formulations and implications and assessing the outcome through ratio analysis. It also broadens the horizon of analysis for the general public and investors in the case of listed entities since very little or not everything about the company is subject to public reporting. The ratio analysis is popularly used in the fundamental analysis of share prices to determine whether the earnings follow the share price of the company or whether the share is simply over priced. 

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FAQs

Q: How does ratio analysis help in assessing the solvency position of an entity?

Ans:

Ratio analysis also helps in assessing the solvency position of an entity. Whether the firm has sufficient liquidity to cover its debt obligations both short term and long term. Short term debt obligations may include, Overdraft, cash Credit, and Interest on term loans. Long term debt obligations may include future interest payments and the Principal amount of term loans.

Q: How is ratio analysis helpful?

Ans:

Ratio analysis helps in finding trends in the financial statements, it can be a trend of continuous decline in performance or profit or a sharp increase. In both cases, Ratios help to locate the problem areas.

Q: What are the various kinds of Ratio Analysis?

Ans:

There can be various kinds of ratio analysis. Here are the most common of all - 

  • Efficiency Ratio
  • Profitability Ratio
  • Debt Coverage Ratio
  • Liquidity Ratio
  • Solvency Ratio
  • Share Price Ratio

Q: What is Ratio Analysis as a Technique?

Ans:

Ratio analysis is a mathematical technique for analyzing a company's financial documents, such as the balance sheet and income statement, to gather knowledge about its liquidity, operational effectiveness, and profitability. Fundamental equity research is built on ratio analysis. Financial ratio analysis is another tool that a company's management can use to gauge how well assets and liabilities are managed. Ineffective use of resources like machinery, property, and buildings leads to excessive costs that need to be cut. Financial ratios can also be used to assess whether financial resources are being used too much or too little.

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The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.

Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.