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As an investor, it is difficult to interpret and read financial statements, given our time constraints. Instead, we prefer relying on the analysis given by analysts. Analysts use different tools to determine the financial condition of a company. One such tool is ratio analysis. Through ratio analysis, they determine a business’s profitability, liquidity, efficiency, and solvency. Also, there are several types of ratios that analysts use to ascertain a company. As an investor, you must know the different types of ratio analysis and their advantages and limitations.
What is Ratio Analysis?
Ratio analysis is a quantitative method that helps ascertain a company’s profitability, liquidity, and operational efficiency. It is the main tool in fundamental analysis. Ratio analysis helps in analysing the financial health of a company. You can also determine how a company’s performance compares to another similar company over time.
Ratios are never used in isolation, instead, they are used in combination with other ratios to better understand whether the company’s financial position has improved or deteriorated over time. It is a tool used by both internal and external parties in a company. Internal users are management and employees. Also, they use it to ascertain the company’s performance and whether they are on track to meet their goals and objectives. External users are analysts, credit rating companies and investors. They use ratio analysis to determine whether the company is investment-worthy or not.
Different Types of Ratio Analysis
There are several types of accounting ratios that help in analysing a company. They can be broadly categorised into five different types.
Liquidity Ratios
Liquidity ratios measure the company’s ability to repay its short and long-term obligations. There are three types of liquidity ratios namely current ratio, quick ratio, and cash ratio.
1. Current ratio
The current ratio is a measure of the company’s ability to pay its short-term liabilities with current assets. Also, it indicates the company’s liquidity. The higher the ratio, the higher its liquidity. However, the ideal current ratio is 2:1. Anything higher than this indicates the company is not putting its excess cash to good use. However, there is one drawback of the current ratio that it cannot be used in isolation to compare different companies.
Current ratio = Current assets/Current liabilities
2. Quick ratio
Quick ratio or acid test ratio is a measure of the company’s ability to pay its short-term liabilities with quick assets. The quick assets are current assets without inventory and prepaid assets. The higher the ratio, the higher its liquidity. The ideal quick ratio is 1:1. Though this ratio can be used to compare different companies, it doesn’t consider future cash flows and the long-term liabilities due within 12 months.
Quick ratio = (Current assets – inventory – prepaid assets)/Current liabilities
3. Cash ratio
The cash ratio measures the company’s capacity to repay short-term liabilities with its cash and cash equivalents. A high cash ratio indicates the company is cash rich. However, companies are not advised to maintain a high level of cash. Hence cash ratio is hardly used in financial analysis.
Cash ratio = Cash and cash equivalents/Current liabilities
Profitability Ratios
Profitability ratios measure the company’s profits in relation to revenue and assets. It also tells the company’s financial health. The higher the profitability ratios, the better the company’s profit-generating capacity. Profitability ratios are also known as performance ratios. Analysts use five different types of profitability ratios to determine the company’s ability to generate profits.
1. Gross profit margin
The gross profit ratio measures the company’s profits from selling its goods and services. It takes into account the net sales and all expenses that the company incurred to produce goods and services. A high gross profit margin indicates the company’s efficiency in selling goods and services. One drawback of gross profit margin is that it doesn’t consider corporate or indirect expenses, such as marketing and distribution expenses that the company incurs to sell goods and services.
Gross profit margin = ((Net Sales – Cost of goods sold)/Net sales) * 100
2. Net profit margin
Net profit margin indicates how much profit is generated for every rupee of revenue earned. The higher the net profit, the greater the company’s ability to generate profits. It is the most important indicator as it tells how profitable the company is. It considers all direct and indirect income and expenses before determining the company’s profitability. Hence even one off-time, such as profit or loss from the sale of an asset, can affect the company’s profitability.
Net profit margin = ((Revenue – Operating and non-operating expenses)/Revenue)*100
3. Return on capital employed (RoCE)
Return on capital employed measures the company’s ability to generate profits from its capital. A high RoCE indicates that the company is using its capital efficiently. This ratio is used for companies that are capex-heavy. It is a very good tool for comparing companies with different capital structures. However, the ratio is calculated based on the book value of assets and liabilities and doesn’t consider the market value.
RoCE = EBIT/Capital Employed
Where EBIT is earnings before interest and tax
Capital employed = Total assets – Current liabilities
4. Return on equity (RoE)
Return on equity measures the profits from the equity invested. In other words, it tells how much profit the company made using shareholder funds. The higher the RoE, the greater the return for the shareholders. As an investor, you can look at the RoE of different companies and compare them to make an investing decision. However, RoE can be easily manipulated by increasing the asset life or decreasing the depreciation rate.
RoE = Net Profit/Average shareholder’s equity
Where the average shareholder’s equity is the average of two years.
5. Return on assets (RoA)
Return on assets (RoA) measures the profits against the assets. It indicates how well the company is using its assets to generate profits. In other words, it measures the company’s ability to generate profits using the assets. RoA is not a very useful measure for service-oriented companies as their asset base is usually low, and they do not incur a lot of capex as well.
RoA = EBIT/Average total assets
Where EBIT is earnings before interest and tax
Average total assets are the average assets of two years
Solvency Ratios
Solvency ratios, also known as leverage ratios, measure the company’s solvency. In other words, these ratios determine whether the company is able to pay back its debt and interest obligations. There are two types of leverage ratios that analysts and investors use for analysis. They are the debt-to-equity ratio and interest coverage ratio.
1. Debt-to-equity ratio
The debt-to-equity ratio measures the company’s ability to pay back its debt obligations using its equity. It also tells how much leverage the company is using in its capital. High leverage indicates that the company uses more debt, indicating a higher risk. It means the company uses more outside funds to operate its business. The debt-to-equity ratio is a very useful tool that helps gauge the risk in the business. The only drawback of this ratio is that it cannot be used to compare companies from different industries. This is because some industries have a high capex and hence may require more leverage than others.
Debt-to-equity = Total debt/Shareholder’s equity
2. Interest coverage ratio
The interest coverage ratio measures whether the company is generating enough profit to cover its interest expense. Also, creditors have the first right to the profits of the company. Hence it is important to gauge whether the company’s profits will be sufficient to pay interest on the loan. Moreover, a high ratio is considered better as the company has enough money to pay off the interest.
Interest coverage ratio = EBIT/Interest expense
Where EBIT is earnings before interest and tax
Turnover Ratios
Turnover ratios indicate how well the company uses its assets and liabilities to generate revenue. They are also known as efficiency ratios, as they determine how efficient the company’s management is. There are three turnover or activity ratios that investors use for analysis: fixed asset turnover ratio, inventory turnover ratio and receivables turnover ratio.
1. Fixed asset turnover ratio
The fixed asset turnover ratio measures how efficiently a company generates revenue from its fixed assets. Also, a high ratio implies that the company efficiently uses its fixed assets to generate revenue. On the other hand, a low ratio implies that the business is underperforming.
Fixed asset turnover ratio = Net sales/Average fixed assets.
2. Inventory turnover ratio
The inventory turnover ratio measures the speed at which the company converts its inventory into sales. Also, it indicates the number of times the inventory is converted and sold to customers in a year. A high ratio signals strong sales, and a low ratio indicates weak sales. But a high ratio can also mean the company is stocking its inventory inadequately.
Inventory turnover ratio = Cost of goods sold/Average inventory
3. Receivables turnover ratio
The receivables turnover ratio measures the speed at which the company can collect its receivables. It indicates the number of times the receivables are converted into cash during a year. A high ratio indicates the company has quality customers and good collection efficiency. On the other hand, a lot ratio indicates the company’s debtors are not financially viable and might lead to bad debts.
Receivables turnover ratio = Net credit sales/Average receivables
Valuation Ratios
Also known as the earnings ratio, they determine whether the company is a good investment or not using the share price. Hence these ratios are also known as market ratios. Also, analysts usually use these ratios to predict the company’s future performance. There are four different types of earnings ratios that you can use for analysis.
1. Earnings per share (EPS)
Earnings per share is the net profit earned per outstanding equity share. Also, it is a widely used metric that indicates how much profit the company makes for each share. A high EPS indicates that the company is making more profits. Hence shareholders will be willing to pay more for the company’s shares. However, EPS doesn’t factor in the cash flow. The shareholders don’t know how much cash will they receive in the form of dividends just by seeing the EPS.
EPS = Net profit/Total number of outstanding shares
2. Price to earnings ratio (P/E)
The price-to-earnings ratio indicates the price an investor is willing to pay for every rupee of earnings. It also tells whether the share is overvalued or undervalued compared to its peers. A high P/E ratio usually indicates that the company is overvalued. However, if the investors expect a company’s earnings to increase in the near term, the P/E ratio tends to increase. A low ratio might indicate that either the company is undervalued or the investors are not positive about the company’s future. Hence P/E ratio shouldn’t be considered in isolation while valuing a company.
P/E ratio = Share Price/Earnings per share
3. Price to book value (P/B)
Price to book value compares the firm’s market value to its book value. A P/B ratio under one is considered good as this shows the company’s intrinsic value is higher and that it has scope for growth in the near future. A high P/B ratio indicates that the company’s shares are overvalued compared to its peers. However, the P/B ratio doesn’t consider the value of intangibles such as goodwill and brand value.
P/B ratio = Share price/Book value per share
Where Book value per share = (Assets – Liabilities)/Outstanding shares
4. Dividend yield
Dividend yield measures the return an investor would earn solely based on the dividend payments. Also, the dividend yield takes into account the current share price and dividend payment. A high dividend yield would mean the return is high, but it can also mean the share price is falling. In contrast, a low dividend yield indicates low return, which can also mean the share price is rising.
Dividend yield = Annual dividend per share/Share price
Frequently Asked Questions
Ratio analysis is a tool that analyses each line item of the financial statements to determine the financial health of a business. You can tell whether the company’s health has improved or deteriorated over time through ratio analysis. Ratio analysis can also be used to compare a company’s financials with its peers or the industry.
Ratio analysis uses historical data to analyse a company’s health. Moreover, it doesn’t consider any external factors that affect a business. It solely concentrates on the company’s financials.
Ratio analysis is used by both internal and external parties to a company. Internal users are promoters, employees, and management. They use it to ascertain how the company is performing and whether they are on track towards meeting their objectives. External users are analysts, investors, credit rating agencies, and competitors. They use ratio analysis to determine whether the company is investment-worthy or not and whether it can meet its outside obligations on time.
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