Chapter 5: Ratio Analysis
What Is Ratio Analysis?
Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational
efficiency, and profitability by studying its financial statements such as the balance sheet and
income statement. Ratio analysis is a cornerstone of fundamental equity analysis.
Objectives of Ratio Analysis
Interpreting the financial statements and other financial data is essential for all stakeholders of an
entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management.
Let us take a look at some objectives that ratio analysis fulfills .
1] Measure of Profitability
Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5 lakhs
last year, how will you determine if that is a good or bad figure? Context is required to measure
profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio, Expense
ratio etc provide a measure of the profitability of a firm. The management can use such ratios to find
out problem areas and improve upon them.
2] Evaluation of Operational Efficiency
Certain ratios highlight the degree of efficiency of a company in the management of its assets and
other resources. It is important that assets and financial resources be allocated and used efficiently to
avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any
mismanagement of assets
3] Ensure Suitable Liquidity
Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So
the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm
maintain the required level of short-term solvency.
4] Overall Financial Strength
There are some ratios that help determine the firm’s long-term solvency. They help determine if
there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need to
quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-
Equity Ratio, Leverage ratios etc.
5] Comparison
The organizations’ ratios must be compared to the industry standards to get a better understanding
of its financial health and fiscal position. The management can take corrective action if the
standards of the market are not met by the company. The ratios can also be compared to the
previous years’ ratio’s to see the progress of the company. This is known as trend analysis.
Advantages of Ratio Analysis
When employed correctly, ratio analysis throws light on many problems of the firm and also
highlights some positives. Ratios are essentially whistleblowers, they draw the managements
attention towards issues needing attention. Let us take a look at some advantages of ratio analysis.
Ratio analysis will help validate or disprove the financing, investment and operating
decisions of the firm. They summarize the financial statement into comparative figures, thus
helping the management to compare and evaluate the financial position of the firm and the
results of their decisions.
It simplifies complex accounting statements and financial data into simple ratios of operating
efficiency, financial efficiency, solvency, long-term positions etc.
Ratio analysis help identify problem areas and bring the attention of the management to such
areas. Some of the information is lost in the complex accounting statements, and ratios will
help pinpoint such problems.
Allows the company to conduct comparisons with other firms, industry standards, intra-firm
comparisons etc. This will help the organization better understand its fiscal position in the
economy.
Limitations of Ratio Analysis
While ratios are very important tools of financial analysis, they d have some limitations, such as
The firm can make some year-end changes to their financial statements, to improve their
ratios. Then the ratios end up being nothing but window dressing.
Ratios ignore the price level changes due to inflation. Many ratios are calculated using
historical costs, and they overlook the changes in price level between the periods. This does
not reflect the correct financial situation.
Accounting ratios completely ignore the qualitative aspects of the firm. They only take into
consideration the monetary aspects (quantitative)
There are no standard definitions of the ratios. So firms may be using different formulas for
the ratios. One such example is Current Ratio, where some firms take into consideration all
current liabilities but others ignore bank overdrafts from current liabilities while calculating
current ratio
And finally, accounting ratios do not resolve any financial problems of the company. They
are a means to the end, not the actual solution.
Ratio Analysis Categories
The various kinds of financial ratios available may be broadly grouped into the following six
silos, based on the sets of data they provide:
1. Liquidity Ratios
Liquidity ratios measure a company's ability to pay off its short-term debts as they become due,
using the company's current or quick assets. Liquidity ratios include the current ratio, quick ratio,
and working capital ratio.
2. Solvency Ratios
Also called financial leverage ratios, solvency ratios compare a company's debt levels with its
assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long
haul, by paying off its long-term debt as well as the interest on its debt. Examples of solvency
ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.
3. Profitability Ratios
These ratios convey how well a company can generate profits from its operations. Profit margin,
return on assets, return on equity, return on capital employed, and gross margin ratios are all
examples of profitability ratios.
4.Turnover/ Efficiency Ratios
Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets
and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover
ratio, inventory turnover, and days' sales in inventory.
5. Earning Ratios
These are the most commonly used ratios in fundamental analysis. They include dividend
yield, P/E ratio, earnings per share (EPS), and dividend payout ratio. Investors use these metrics
to predict earnings and future performance.
