There are different methods and tools used assess the financial standing of a company. Ratio Analysis is one such method by which we can determine the financial position of a company. Ratio analysis is a quantitative method by which we can determine the profitability, liquidity and efficiency of a company by analyzing the financial statements of a company such as balance sheet and income statement.
Significance of Ratio Analysis
Ratio analysis is a useful method for investors and analysts to assess the financial health of a company. This is done by analyzing past and current financial statements of the company. The ratio analysis is used by the analysts for the following purposes:
Assessing the Financial Health of a Company
Ratio analysis tells us about how financially sound a company is? A company having good profitability ratio, solvency ratio and liquidity ratio is considered financially stable as it is generally considered profitable, having sufficient cash flow and supported by the assets which can be used to pay- off short term and long term loans and obligations during as and when they arise.
Comparing the Financial Performance of a Company
The ratio analysis can also be used to compare the performance and financial standing of a company against the industry benchmark or with its rival companies. The investors and the management use the ratio analysis for making crucial decisions, for example, an investor can compare the P/E ratio of a company for buying or selling the stocks of a particular company.
Efficiency ratios or activity ratios tell us about how efficiently a company is utilizing its resources to generate profits from its operations. The management generally uses this type of analysis to check the efficiency of the operations of a company. If the efficiency ratios are improving as compared to the previous periods or against the industry bench mark, it means that the efficiency of the company is improving. If the efficiency ratios are indicating less efficiency, then the management has to take effective measures to improve the efficiency of the company.
If the management wants to determine a trend in the performance of a company, then the activity ratio or the efficiency of past periods can be seen and compared. The future financial performance of the company can also be predicted by comparing different ratios of many accounting periods.
Types of Ratio Analysis
Liquidity ratios are used to determine a company’s ability to pay-off its short term debts. There are mainly three ratios in this category, namely, current ratio, quick ratio and working capital ratio. In case of any financial problem, the company can pay-off its debts by liquidating its assets. The liquidity ratios are useful tools for the creditors, banks, financial institutions and investors to determine the capacity of a firm to pay off its obligations as they become due in the current financial year.
These are also called financial leverage ratios. These ratios compare a company’s debt with its assets to determine the capacity of the company to remain stable when it comes to paying off long term debts. Some of the common solvency ratios are debt- equity ratio, debt- assets ratio, interest coverage ratio, etc. Solvency ratios are used by the institutional investors, government agencies, etc. to determine the solvency of a company.
These ratios are used to determine how efficiently the company can generate profits from its operations. If a company is showing improved profitability ratio as compared to previous years, it shows that the company is performing well and the business of the company is growing. Profitability ratios are also useful for comparison of the operation of a company with other companies or industry standards. Some of the common profitability ratios include return on capital employed, gross profit ratio, net profit ratio, return on assets, return on equity, etc.
Market Prospect Ratios
These ratios are useful for the investors as they are used in the fundamental analysis of the stocks of a company. Investors use these ratios to predict earnings and future performance of a company. Common market prospect ratios are dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio.
These ratios are used to determine the value of a stock by comparing it with industry standards. For e.g., it the average P/E ratio of a particular industry is 35, then a company having P/E ratio of 22 would be considered undervalued and a company having P/E value would be considered overvalued. P/E ratio generally signifies that how much investors value a particular company and how much they are willing to pay against ₹1 earning of the company. A stock with a high P/E ratio is considered costly and one with a low P/E ratio is considered a cheap stock.
These are also called activity ratios and these ratios determine how efficiently a company uses its resources to generate profits. Some common efficiency ratios are asset turnover ratio, inventory turnover ratio and days’ sales in inventory, etc.
The management or the investors require useful data for decision making. They compare many parameters and numbers together to arrive on a conclusion. The ratio analysis is such a method which provides someone an insight of the company regarding how the company is performing over the time and as compared to its competitors.