What Is Ratio Analysis?

Ratio Analysis is a type of Financial Statement Analysis used to

obtain a rapid indication of a company’s financial performance in
key areas.

You can use Ratio analysis to evaluate various aspects of a

company’s operating and financial performance like its efficiency,
liquidity, profitability, and solvency, etc.

Types of Ratios
Ther are five types of ratios evaluated while performing Ratio
Analysis: growth, profitability, operations, liquidity, and solvency
ratios. Now, let us understand the components of each in brief.

Profitability Ratio

Profitability ratios are financial metrics that help us to know the

ability to generate earnings. This includes Profit Margin, Return on
Assets, Return on Equity, Dividend Payout Ratio, and PE(Price
Earnings) Ratio.

Profit Margin

The profit margin ratio helps us to know the overall percentage of

profit a business makes against its revenue. The formula to
calculate Profit Margin is as below:

Profit Margin = Income From Operations/Total Revenue

Return on Assets

Return on assets indicates how a business is profitable against its

assets. In other words, it determines the efficiency to generate
earnings using its assets. The formula to calculate Return on Assets
is as follows:
 Return on Asset = Net Income/Total Assets

Return on Equity

Similar to Return on Asset, Return on equity is a measure that helps

us to know the effectiveness of equity in generating profits. The
formula to calculate Return of Equity is as follows:

Return on Equity = Net Income/ Average Shareholder’s

Equity

where, Average Shareholder Equity = (Current Year Equity +

Previous Year Equity) / 2

Dividend Payout Ratio

The dividend payout ratio describes the ratio dividend paid to the
shareholders against the net income of the company. The formula to
calculate the dividend payout ratio is as follows:

Dividend Payout Ratio = Dividend Paid / Net Income

Price Earning Ratio (PE Ratio)

The price-to-earnings ratio or PE ratio provides the ratio of earnings

per share against the current market price per share. The formula to
calculate the PE ratio is as follows:

PE Ratio = Market Value Per Share / Earning Per Share

Growth Ratio

Growth ratios are indicators of how fast our business is growing.

These growth ratios include sales growth, income growth, and asset
growth.
Sales Growth

Sales growth is a metric that shows the percentage of increase in

sales over a specific period. Furthermore, it helps us to understand
the demand for products/services in the near future. The formula to
calculate Sales growth percentage is as follows:

Sales Growth = (Current Year Revenue – Previous Year

Revenue)/Previous Year Revenue

Income Growth

Income growth is a metric that shows the percentage of increase in

profit compared to the previous year. Moreover, it helps us to
understand the growth of sales as well as the performance of our
product line. The formula to calculate Income growth is as follows:

Income Growth = (Net Profit Current – Net Profit Previous) /

Net Profit Previous

Asset Growth

Asset growth is a metric that shows the percentage of growth in

assets over a specific period. Hence, it helps to determine the
increase in assets of the business. The formula to calculate Asset
growth is as below:

Asset Growth = (Total Asset Current – Total Asset

Previous) / Total Asset Previous

Activity Ratio

Activity ratios are financial metrics that indicate the efficiency to

leverage its assets to generate revenues and cash. These include
receivables turnover, inventory turnover, and fixed asset turnover.
Receivable Turnover

The receivables turnover ratio is an accounting metric that quantifies

the effectiveness of collecting accounts receivables.

Thus, a higher Receivable turnover indicates the company’s

efficiency in the timely collection of receivables and also good
clientele that pays off debt quickly. The formula to calculate
Receivable turnover is as follows:

Receivable Turnover = Revenue / Average Accounts

Receivables

Where Average (A/R = A/R Current + A/R Previous) / 2.

Inventory Turnover

Inventory turnover is a ratio that shows the number of times a

business replaces its inventory during a given period.

In addition to that, it helps a business in making better decisions

related to pricing, production as well as marketing. The formula to
calculate Inventory Turnover is as follows:

Inventory Turnover = Sales / Average Inventory

Where Average Inventory = (Inventory Current + Inventory

Previous) / 2.

Fixed Asset Turnover

Fixed Asset Turnover Ratio is a metric that defines the ability to

effectively generate sales using its fixed assets.
Thus, a higher Fixed Asset Turnover Ratio indicates efficient use of
its fixed assets in generating sales and vise versa. The formula to
calculate Fixed Asset Turnover is as follows:

Fixed Asset Turnover = Net Revenue / Total Fixed Assets

Liquidity Ratio

Liquidity ratios are financial metrics that help to determine a

business’s ability to pay off its debts without raising external capital.
It includes the Current Ratio and Quick Ratio.

Current Ratio

The current ratio helps to measures the ability to pay short-term

debt obligations within the current period.

Moreover, it helps to know how a business can maximize its current

assets even by paying its current debt and other payables. The
formula to calculate Current Ratio is as given below:

Current Ratio = Current Asset / Current Liabilities

Quick Ratio

Quick Ratio defines a company’s ability to meet its short-term debt

obligations with its most liquid assets.

Furthermore, a higher Quick ratio determines better liquidity and

financial health. Whereas a lower quick ratio defines that the
organization will have difficulties paying its debts. The formula to
calculate the Quick Ratio is as follows:

Quick Ratio = (Cash Equivalents + Inventory + Accounts

Receivable) / Current Liabilities
Solvency Ratio

The solvency ratio determines the ability to meet its long-term debt
obligations. Moreover, a higher solvency ratio indicates an
increased ability to cover its liabilities over a long period.

Debt to Total Asset Ratio

The Debt to Total Assets ratio defines the total amount of debt
relative to assets owned by a company.

While calculating this ratio, all of the company’s debts must be

considered including loans and bonds payable. Similarly, all assets
must be considered including intangible assets. The formula to
calculate Debt TO Total Asset Ratio is as below:

Debt To Total Asset Ratio = Total Liabilities / Total Assets