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Each category of ratio analysis addresses a distinct dimension of corporate performance. Understanding the various types of financial ratios is essential for accurate share evaluation, credit assessment, and fundamental investing.
Ratio analysis is the quantitative process of evaluating a company’s financial health, operational efficiency, and profitability by examining the mathematical relationships between various items on its financial statements.
Here is how to use ratio analysis to assess a company's liquidity, profitability, solvency, and efficiency.
Key Takeaways
- Financial figures are divided into six main categories by ratio analysis, each of which examines a different aspect of the company's financial health.
- A ratio only has any meaning when it is compared with history, with other companies in the same field, or with an industry benchmark.
- Ratios relating to liquidity and solvency help to guard against both short-term and long-term financial difficulty, while those relating to profitability show how efficiently capital is being used.
- The market ratios such as P/E and EPS are most important to investors who buy shares, not to those who are evaluating credit risk.
- Since ratios are based on past data, a good ratio at the present time cannot ensure that the same outcome will be achieved in the next quarter.
What is Ratio Analysis?
Ratio analysis involves selecting two figures that are related from a balance sheet, a profit and loss account, or a cash flow statement and then showing one of them as a proportion of the other.
In this way, the raw figures are transformed into data which can be compared over different time periods, between different companies, and within different sectors. A figure alone such as net profit has very little significance by itself, but when it is divided by revenue, it becomes a profit margin which can then be compared with the figure from last year or with that of a competing firm.
What are the Different Types of Ratio Analysis?
- Liquidity Ratios
- Purpose: Used to determine if a company can meet its short-term obligations with its current assets.
- Key Formula: Current Ratio = Current Assets / Current Liabilities
- Interpretation: A ratio above 1.0 indicates that the business has more short-term assets than short-term debts, signifying a healthy short-term liquidity buffer.
- Solvency (Leverage) Ratios
- Purpose: Assess a company's capacity to handle its long-term debt obligations and survive long-term financial distress.
- Key Formula: Debt-to-Equity Ratio = Total Liabilities / Shareholder's Equity
- Interpretation: A lower ratio generally indicates a more financially stable business model with less reliance on borrowed capital.
- Coverage Ratios
- Purpose: Indicate how easily a company can pay its interest and other fixed financing charges out of its earnings.
- Key Formula: Interest Coverage Ratio = EBIT (Earnings Before Interest and Taxes) / Interest Expense
- Interpretation: A higher number means the company generates more than enough operating income to comfortably service its debt interest expenses.
- Efficiency (Activity) Ratios
- Purpose: Measure the extent to which a company efficiently utilizes its assets, inventory, and receivables to generate sales.
- Key Formula: Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory
- Interpretation: A higher turnover rate signifies efficient inventory management and strong sales conversion.
- Profitability Ratios
- Purpose: Show the amount of net profit that a company extracts from its revenue, total assets, or equity base.
- Key Formula: Net Profit Margin = (Net Income / Revenue) * 100
- Interpretation: A higher percentage indicates that a larger portion of revenue successfully translates into bottom-line profit.
- Market Prospect Ratios
- Purpose: Allow investors to gauge market expectations regarding a share's valuation and future performance.
- Key Formula: Price-to-Earnings (P/E) Ratio = Current Share Price / Earnings Per Share (EPS)
- Interpretation: A high P/E ratio often implies that investors expect higher future growth, whereas a lower ratio may point to an undervalued stock or underlying business challenges.
How do You Calculate a Financial Ratio?
All ratios have the same basic structure, namely one financial figure being divided by another figure closely related to it. For instance, consider the current ratio, which is a measure of liquidity.
Formula: Current Ratio = Current Assets / Current Liabilities
Current Assets = cash, inventory, receivables, and other assets convertible to cash within a year.
Current Liabilities = dues payable within a year.
If a company has current assets amounting to ₹8,00,000 and current liabilities of ₹3,00,000:
Current Ratio = 8,00,000 divided by 3,00,000 = 2.67 (which is a satisfactory level of liquidity).
Which Ratios Matter Most for Stock Evaluation?
When people choose stocks, they usually rely on four ratios more than any others.
The P/E ratio is calculated by dividing the share price by the earnings per share. If a stock has a high P/E when compared to other companies in the same industry, it may indicate that the stock is priced in anticipation of future growth that has not yet materialized.
EPS is equal to net profit divided by the total number of outstanding shares, and if it rises over a number of quarters, this generally indicates real earnings strength.
The dividend payout ratio is equal to the dividends paid divided by the net annual earnings, and if the payout ratio is over 100%, then the company is paying out more than it earns, which is not sustainable.
The price-to-book ratio is defined as the market price per share divided by the book value per share, and value-oriented investors generally look for a low PB ratio in comparison to that of the sector.
Liquidity Ratios vs. Solvency Ratios
People often confuse these two categories since both of them concern debt. The table below clearly distinguishes between them.
| Factor | Liquidity Ratios | Solvency Ratios |
| Time frame | Short-term, within a year | Long-term, beyond a year |
| Question answered | Can the company pay bills due soon | Can the company survive its long-term debt |
| Key ratios | Current ratio, quick ratio | Debt-equity ratio, debt-assets ratio |
| Used mainly by | Suppliers, short-term lenders | Bondholders, long-term lenders, banks |
| Warning sign | Ratio falling below 1 | Debt growing faster than equity |
Why Ratio Analysis Matters
Ratio analysis converts the detailed information in financial statements into figures which can be easily compared.
It enables one to determine if profitability is increasing or decreasing, whether debt is being managed properly, and if the company's operations are becoming more or less efficient over a number of reporting periods.
When people are comparing two companies in the same industry, ratios eliminate the effect of company size and allow performance to be judged by itself.
Limitations of Ratio Analysis
Although ratios can be useful, they are by no means perfect and it's worth being aware of a few limitations before relying on them too much.
Since ratios are based on historical financial statements, they provide little information regarding future events.
Inflation can cause the figures reported years apart to be miscomparable.
A switch in the accounting policy can cause the ratios to change even if there has been no actual alteration in business performance.
Rates computed on their own, without reference to an industry standard, can mislead rather than provide useful information.
A single event, for example the sale of an asset, can cause a ratio to rise in one quarter without indicating anything about the actual business operations.
How Should Ratios be Compared
By itself a ratio tells us very little; it is the context that gives it any value. Look at the trend over time by checking the same ratio in a number of quarters to determine the direction it is moving.
You should compare the company with other firms in the same sector by looking at their ratio, since there is a great deal of variation in capital structure and business models between sectors.
Further, check the ratio against an internal target or a threshold established by the lender, since failing to meet the lender's benchmark could trigger loan covenants.
Conclusion
Ratio analysis involves breaking down a company's financial statements into figures which can be compared and understood. Ratios relating to liquidity and solvency indicate financial stress before it turns into a crisis, profitability ratios show how effectively a business converts revenue into profit, and market prospect ratios provide an indication of what a stock might be worth in the future.
Yet none of these figures are of any use by themselves. A ratio only acquires meaning when it is compared with the company's past performance, with other companies in the same industry, and with the sector as a whole.
