A doctor’s job is to make sure that his patients are healthy and free from illness. Your doctor does a full-body checkup to assess your vital signs, such as blood pressure, heart rate, and temperature. These checkups can give an overview of your current health condition. Well, a ratio analysis also works to give an overview, but financially!
Financial ratio analysis uses ratios to evaluate a company’s performance. It relies on numbers from financial statements. This process reveals a business’s health, efficiency, stability, and profitability. Key documents include balance sheets and cash flow statements. These are essential for performance assessment and growth prediction.
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Financial Ratio Analysis: Definitions and types
Financial ratio analysis is a method to examine a company’s financial well-being. It uses the company’s financial statements to get an idea of how it is performing financially.
Financial analysis generally falls under these categories:
- Liquidity ratios
- Solvency
- coverage
- profitability
- Efficiency
Liquidity ratios
Liquidity ratio checks if a company can repay its short-term debts, based on its current financial state. It also measures the company’s ability to meet current obligations without needing extra funds.
The common liquidity ratios are as follows:
Current ratio
The current ratio is based on current short-term liabilities and current assets. If the company can pay short-term debts in its current financial situation. Current assets are assets that are available to be used as convertible cash, so a company can use them to cover expenses.
Current Ratio = Current Liabilities / Current Assets
Quick ratio
The quick ratio indicates whether a company can pay current short-term debts with quick assets. Quick assets are also known as acid-test assets; they are assets that are quick to be used as convertibles. Quick ratios do have to rely on current sales to cover liabilities.
Cash ratio
Cash ratios is a measure of whether a company short-term debts in its current financial situation,using only cash and its equivalent.
Liquidity ratios are like a fuel gauge for a car! Like fuel gauges, which show how much fuel is left and how many kilometres they can take you smoothly, liquidity ratios show how well your business can run on its current state of fuel.
Solvency ratios
Solvency ratios check if a company can repay its long-term debts. They are key indicators of financial health, assessing cash flow balance. The solvency ratio tells you if the company has the financial stability to handle long-term liabilities or is burdened.
Solvency ratios include debt and equity assets. Potential lenders often use solvency ratios. They help assess whether a company can repay its debts and liabilities. Solvency ratios show whether a business is good for long-term investment.
Think of yourself as the builder of a bridge! As a good builder, you will ensure that the bridge supports itself in the long run, like in years and decades to come. Solvency is a key factor in ensuring a business’s financial stability in the coming years.
Profitability ratios
Professional financial ratios analyze how much profit a company is generating from its operations, such as goods and services. It is a measure to evaluate a company’s income-to-revenue ratio, taking into account profits, margins, managing costs, equity, etc. Data is used over a specific period of time to evaluate profit.
Profitability ratios are calculated by dividing net income by net revenue.
Profitability ratios = Net income/revenue × 100
Coverage ratios
Coverage ratios are a measure of a company’s ability to fulfill financial liabilities, such as paying interest and clearing debts. The higher the coverage, the easier it will be to pay for debt and interest. Coverage ratios can help in finding a company’s potential financial disturbances.
Coverage ratios are calculated by dividing earnings by interest.
Efficiency ratios
Efficiency ratios analyze how well a business is using its resources to increase sales and maximize its profits. They calculate how the company manages its resources, collects turnover, tracks equity usage, etc. Efficient ratios can also measure how investment banks manage their operations and funds.
Efficiency ratios are calculated by dividing revenue by expenses.
Efficiency ratio = Revenue / Expenses
How does it work?
Like a full-body checkup, where a doctor assesses a patient’s current symptoms and past medical history to determine their health. Ratio analysis works like a full-body checkup on a company by assessing its current and previous financial systems.
The ratios obtained by different metrics of financial ratio analysis are used to:
- Analyze financial performance by following past and current trends in growth.
- Predict and evaluate further credibility and stability. Both in the short and long run.
- Ratios help assess a business’s market value against industry averages.
- Determines how well a company performs compared to its competitors. This creates a scope for its future performance.
- Ratio analysis provides insights to improve the growth of a business.
Limitations of financial ratio analysis.
- Ratio analysis should not be used separately. It should be used alongside other financial measures to have a bigger picture of the company’s financial stance in the market.
- Ratio analysis excludes external factors like economic changes, trends, and other factors that can affect performance.
Bottom line, to get overall insights about the company’s performance, a lot of factual data needs to be incorporated. It can be complex and overwhelming, but ratio analysis can provide valuable information regarding companies’ sales and growth over time.
Just like a successful trip needs good packing arrangements to ensure a smooth journey. It is a game of financial metrics where ratio analysis can make arrangements go swiftly.
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Disclaimer – This article is for educational purposes only and by no means intends to substitute expert guidance. Mutual fund investments are subject to market risks. Please read the scheme-related documents carefully before investing.
