Ratio Analysis: Definition, Uses, Types and many more...

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Finance | Ratios | Definition | Uses | Types | 





RATIO ANALYSIS | DEFINITION |

Ratio analysis refers to the comparison between different pieces of financial information in the financial statements. various aspects like liquidity, profitability, and insolvency can be analyzed with the help of ratios. Analysts rely on current and past financial statements to obtain the correct data to evaluate the financial performance of a company. They also use the data to determine if a company’s financial health is on an upward or downward trend and draw a comparison against other competing firms.

USES OF RATIO ANALYSIS:-


Ratio analysis is generally used for:- 
  1. Comparisons
  2. Trend line
  3. Operational efficiency


TYPES OF RATIOS:- 


Plenty of Ratios are possible to do the ratio analysis of the financial statements and they are grouped into the following categories

Five groups may be used as under
  1. Liquidity Ratios
  2. Leverage Ratios
  3. Profitability Ratios
  4. Efficiency Ratios
  5. Working Capital Ratio



1. Liquidity Ratios:-

1.1. CURRENT RATIO:-


  • Purpose: Analyse short-term liquidity of the Company
  • Calculation:

                  Current Ratio =  Current assets / Current liabilities

  • Analysis Aspect:
  1. Ideally should be greater than 1.
  2. Higher the better (unless there are reasons otherwise)
  • Interested Stakeholders:
Banks, Management, RM  Suppliers

1.2. QUICK RATIO (or Acid Test Ratio)

  •  Purpose: Analyse immediate liquidity position of the Company
  •   Calculation:

                Current Ratio =  (Current assets - Inventory) / Current liabilities

  •    Analysis Aspect:
  1.  Ideally should be greater than 1.
  2. Higher the better (unless there are reasons otherwise)
  • Interested Stakeholders:
               Banks, Management, RM  Suppliers



2. Leverage Ratio 

2.1. Debt – Equity Ratio

  • Purpose: Long-term solvency of the company
  • Calculation:

                Debt – Equity Ratio = Long term debt / Share Holders Equity

  • Analysis Aspect:
  1. Leverage increases the ‘Bankruptcy Risk’, so lower the better
  2. But, leverage also provides tax cushion and increases Return for shareholders, so the company tends to take debt.
  • Interested Stakeholders:
                Shareholders, Lenders (Banks)

2.2. Interest Coverage Ratio

  •  Purpose: How easily a company can pay the interest obligations on its Debt
  • Calculation:

              Interest Coverage Ratio =  EBIT / Interest ( WC + Term Loan )

  •  Analysis Aspect:
  1.  Higher the better
  • Interested Stakeholders:
                 Shareholders, Lenders (Banks)

3. Profitability Ratios (Related to Sales)

3.1. EBITDA Margin

  •  Purpose: Determine how profitable the core business of the Company is.
  • Calculation:

                  EBITDA Margin = EBITDA / SALES

  • Analysis Aspect:
  1. Total Cost as the % of Sales
  2. Higher the better
  • Interested Stakeholders:
              Management, Shareholders, Lenders (Banks)


 3.2. Operating Profit Ratio
  •  Purpose: Determine how profitable the core business of the Company is.
  • Calculation:

                     Operating Profit = EBIT / Total Income

  • Analysis Aspect:
  1. Total Cost including Depreciation as the % of Sales
  2. Higher the better
  •  Interested Stakeholders:
               Management, Shareholders, Lenders (Banks)


 3.3. Net Profit Ratio

  • Purpose: How much money the business is generating for its shareholders.
  • Calculation:

                  Net Profit Ratio =  PAT / Total Income ( Net Sales + Other Income )

  • Analysis Aspect:
  1. Higher the better
  • Interested Stakeholders:
               Management, Shareholders, Lenders (Banks)

  (Related to Investment)

3.4. Return on Assets

  • Purpose: Determine how efficient management is at using its assets in generating revenues.
  • Calculation:

                    Return on Assets = PAT/ Total assets

  • Analysis Aspect:
  1. Higher the better
  2. Tests the management efficiency
  • Interested Stakeholders:
               Management, Shareholders, Lenders (Banks)

 3.5. Return on Capital Employed 

  • Purpose: Determine the Company’s profitability and how efficiently the capital is employed.
  • Calculation:

                Return on Capital Employed = EBIT /  Total Capital Employed

  • Analysis Aspect:
  1. Higher the better
  2. Tests the management efficiency in deploying the capital
  • Interested Stakeholders:
                Shareholders, Lenders 

3.6. Return on Equity

  • Purpose: Income returns as a % of shareholders' equity.
  • Calculation:

            Return on Equity = PAT / Shareholders Equity 

  • Analysis Aspect: 
  1. Higher the better
  2. ROE of 17% to 18% is considered good
  • Interested Stakeholders:
               Shareholders

 (Related to Equity Shares) 

3.7. Earnings Per Share

  • Purpose: Monetary value of earnings per outstanding stock of the company.
  • Calculation:

      Earnings Per Share = Net Profit available to Equity Shareholders / Number of Equity Shares

  • Analysis Aspect:
  1. Higher the better
  2. Should be seen in comparison to share price
  • Interested Stakeholders:
             Shareholders 

3.8. Price to Earnings Ratio (P/E Ratio)

  • Purpose: How is the market valuing the share as against the earnings per share.
  • Calculation:

              PE Ratio = Market Price Per Share / EPS

  • Analysis Aspect:
  1. High value can indicate investors are paying a higher price for the stock as against its earnings
  2. Low PE may indicate the investors aren’t very confident about the company’s prospect or the share is under-priced
  • Interested Stakeholders:
              Shareholders

 
4. Activity, Efficiency or Turnover Ratios

4.1. Asset Turnover

  • Purpose: Efficiency in Asset management.
  • Calculation:

                  Asset Turnover = Sales / Total Assets

  • Analysis Aspect:
  1. Higher the better
  • Interested Stakeholders:
                    Management

 4.2. Inventory Turnover

  • Purpose: Efficiency in management of Inventory.
  • Calculation:

                   Inventory Turnover = COGS / Average Inventory

  • Analysis Aspect:
  1. Higher the better
  • Interested Stakeholders:
                  Management

4.3.Debtors Turnover

  • Purpose: How efficiently the Company is able to collect its Debtors (Receivables).
  • Calculation:

                   Debtor Turnover = Gross Sales / Average Debtors

  • Analysis Aspect:
  1. Higher the better
  • Interested Stakeholders:
                    Management


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