Financial Ratio Analysis: Definition, Types, Examples, and How to Use | Financial Management & Strategic Management for CA Intermediate PDF Download

What is Ratio Analysis?

Ratio analysis is a fundamental tool used to evaluate the financial performance of a company by analyzing the relationships between various financial variables. It helps in assessing the efficiency, profitability, and liquidity of a business.

Key Takeaways

• Ratio analysis involves comparing different line-item data from a company's financial statements to gain insights into its profitability, liquidity, operational efficiency, and solvency.
• It helps assess a company's performance over time and allows for comparisons with other companies within the same industry or sector.
• External parties often use ratio analysis to set benchmarks and assess risk.
• While ratios provide valuable insights, it's essential to combine them with other metrics to get a comprehensive view of a company's financial well-being.
• Examples of ratios used in analysis include the current ratio, gross profit margin ratio, and inventory turnover ratio.

What Does Ratio Analysis Tell You?

Investors and analysts use ratio analysis to assess companies' financial health by analyzing past and present financial statements. Comparative data show how a company has performed over time and can predict future performance. This data also compares a company's financial position with industry averages and evaluates its standing within the sector.

Ratio analysis is easily accessible for investors, as all the necessary figures are available in company financial statements. Ratios serve as benchmarks for comparing companies within an industry and measuring a company's current performance against its historical data. It's crucial to understand the factors influencing ratios because management can adjust strategies to improve ratios and enhance the company's attractiveness to investors.

Ratios are most effective when used together with other ratios, providing a comprehensive view of the company from various perspectives and helping identify potential issues.

Types of Ratio Analysis

Financial ratios are categorized into six main groups based on the data they provide:

• Liquidity Ratios: These assess a company's ability to meet short-term debts using current or quick assets. Examples include the current ratio, quick ratio, and working capital ratio.
• Solvency Ratios: Also known as financial leverage ratios, these compare a company's debt levels with its assets, equity, and earnings to determine its long-term stability. Examples include debt-equity ratios, debt-assets ratios, and interest coverage ratios.
• Profitability Ratios: These indicate how effectively a company generates profits from its operations. Examples include profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios.
• Efficiency Ratios: Also called activity ratios, these measure how efficiently a company utilizes its assets and liabilities to generate sales and profits. Examples include turnover ratio, inventory turnover, and days' sales in inventory.
• Coverage Ratios: These assess a company's ability to meet interest payments and other debt obligations. Examples include times interest earned ratio and debt-service coverage ratio.
• Market Prospect Ratios: These are commonly used in fundamental analysis and include metrics like dividend yield, P/E ratio, EPS, and dividend payout ratio. Investors use these ratios to forecast earnings and future performance.

For instance, consider the P/E ratio. If the S&P 500 index's average P/E ratio is 20 and most companies have P/Es between 15 and 25, a stock with a P/E of seven might be undervalued, while one with a P/E of 50 could be overvalued. This information helps investors assess a stock's potential future trend based on its valuation relative to its peers.

Application of Ratio Analysis

The application of ratio analysis involves comparing various figures to derive calculated values. These values, on their own, may not provide significant insights. Therefore, ratio analysis is typically applied in comparison to determine the financial health of a company—whether it is strong, weak, improving, or deteriorating.

Ratio Analysis Over Time

Companies use ratio analysis over time to gain a deeper understanding of their performance trajectory. Rather than focusing solely on the current state, they analyze how their performance has evolved over time, identifying successful changes and persistent risks. This analysis is crucial for making long-term decisions and strategic plans.

For instance, a company may choose a specific financial ratio and calculate it regularly, such as monthly. It's important to consider seasonality and temporary fluctuations in account balances that may affect month-to-month ratio calculations. By tracking changes in the ratio over time, companies can assess improvement, the pace of change, and whether the desired trends are being achieved.

Ratio Analysis Across Companies

Ratio analysis becomes pivotal for a company when it realizes that despite having a 10% gross profit margin, its competitors are achieving a substantial 25%. This underscores the importance of understanding where a company stands relative to its industry peers.

For effective ratio analysis across companies, it's crucial to focus on comparing similar firms within the same industry. Additionally, one should consider how differences in capital structures and company sizes can affect operational efficiency. Moreover, varying product lines, such as technology companies offering both products and services, can introduce complexities in ratio analysis due to the different impacts these lines may have on financial metrics.

Note: Different industries simply have different ratio expectations. A debt-equity ratio that might be normal for a utility company that can obtain low-cost debt might be deemed unsustainably high for a technology company that relies more heavily on private investor funding.

Ratio Analysis Against Benchmarks

• Companies often establish internal targets for their financial ratios, aiming to maintain current levels or achieve operational growth. For instance, if a company's current ratio is 1.1 and it seeks increased liquidity, it may set a target of 1.2 by the fiscal year's end.
• External entities like lenders also use benchmarks. Lending institutions include financial health requirements in loan covenants, which are part of the loan terms. Companies must meet specified metrics, or the loan may be called back.
• Failure to meet these benchmarks can lead to the loan being callable, or the company facing higher interest rates to offset the risk. For instance, a common benchmark set by lenders is the debt service coverage ratio, which assesses a company's cash flow against its debt obligations.

Examples of Ratio Analysis in Use

Ratio analysis offers insights into a company's future performance, which can be either promising or concerning. Strong companies typically exhibit robust ratios across all categories, and any sudden weakness in a specific area may trigger a significant stock sell-off. Let's explore a few straightforward illustrations.

The net profit margin, also known as profit margin or bottom line, is a metric investors use to assess the profitability of companies within the same industry. It's derived by dividing a company's net income by its revenues. Instead of delving into financial statements for comparative profitability analysis, investors rely on this ratio. For instance, consider companies ABC and DEF in the same sector, with profit margins of 50% and 10%, respectively. An investor can quickly gauge that ABC turns 50% of its revenues into profits, whereas DEF only achieves a 10% conversion rate.

Taking the example further, suppose ABC has a P/E ratio of 100, while DEF's P/E ratio is 10. An ordinary investor would interpret this as ABC commanding a valuation where investors pay $100 for every $1 of earnings it generates, whereas DEF's valuation is $10 per $1 of earnings.

What Are the Types of Ratio Analysis?

Ratio analysis in finance is typically categorized into six main types: profitability ratios, solvency ratios, liquidity ratios, turnover ratios, coverage ratios, and market prospect ratios. Additionally, non-financial metrics may be utilized across different departments and industries. For instance, a marketing team might employ a conversion click ratio to evaluate customer engagement.

What Are the Uses of Ratio Analysis?

Ratio analysis serves three primary purposes. Firstly, it tracks changes within a company over time, aiding in understanding operational trends. Secondly, it facilitates comparison with similar firms to gauge competitive standing. Thirdly, it helps in striving for predetermined benchmarks, whether internal or external.

Why Is Ratio Analysis Important?

Ratio analysis holds significance as it provides a more nuanced view of a company's operations. For example, a company reporting $1 billion in revenue may seem successful, but if it has a negative gross profit margin, declining liquidity ratios, and reduced earnings compared to equity, it indicates underlying challenges that static numbers alone may not reveal.

What is an Example of Ratio Analysis?

Consider the inventory turnover ratio, which measures how efficiently a company converts inventory into sales. By tracking this ratio over a year, a company can assess its monthly performance in converting goods into cash, identifying patterns of efficiency or areas needing improvement.

The Bottom Line

Amidst the wealth of data available, companies can derive greater insights by employing ratio analysis, which involves comparing multiple metrics. This approach helps in understanding performance trends, competitive positioning, and alignment with organizational goals. While traditionally rooted in financial metrics, ratio analysis can also encompass non-financial data for comprehensive analysis.