The Implementation of Ratio Analysis
In ratio analysis, one compares two or more numerical values to arrive at a numerical conclusion. That worth may not amount to much on its own. Instead, it is sometimes necessary to apply ratio analysis to a comparison to ascertain whether a company's financial health is good, weak, improving, or deteriorating.
Ratio Analysis and How It is Used
A corporation may learn more about its future by tracking key performance indicators (KPIs) via ratio analysis over time. This study isn't concerned with the present state of affairs so much as it is with the firm's past performance, the success of previous reforms, and the persistence of any remaining dangers.
Kind of Information to Gather From Ratio Analysis
Explaining Data Gathered by Ratio Analysis
Investors and analysts use ratio analysis to assess a company's monetary well-being by comparing its historical and present financial data. The ability to see how a firm is doing over time and make predictions about its future performance is made possible by comparing it to similar organisations. This information may be used to evaluate a firm's performance relative to competitors in the same field, as well as to assess how the company compares to the average performance of its industry.
Ratio analysis is a simple tool for investors to utilise, and all the data required to compute the ratios is included in a firm's financial statements. Companies might use ratios as benchmarks to gauge their performance. For example, they do industry-specific stock analysis. Similarly, the current version is compared to past financial data.
When analysing ratios, it is crucial to grasp the underlying factors since management may sometimes adjust course to improve stock and business ratios. Most of the time, ratios are used in conjunction with other ratios rather than by themselves. You may get a better picture of the firm and be on the lookout for warning signs if you are familiar with the ratios in the four areas we discussed.
Ratio Analysis and Its Varieties
Applications of Ratio Analysis
Based on their information, the many different financial ratios may be classified into six main buckets.
Ratios of Liquidity
So, what is the liquid ratio? A company's liquidity ratio indicates how quickly it can pay off its short-term obligations using its available liquid assets. The current ratio, the quick ratio, and the working capital ratio are all examples of the accounting ratios formula.
Current Ratio = Current Assets/Current Liability.
Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities
Relative measures of Financial Stability
Solvency ratios, also known as financial leverage ratios, measure a company's ability to pay back its long-term debt and interest payments by comparing its obligation to its assets, equity, and profits. Common solvency ratios include debt-equity, debt-asset, and interest coverage ratios. You can get ratio analysis formulas in PDF or accounting ratios formulas in PDF online.
Debt-to-Equity ratio = (Net debt) / (Shareholders' equity).
Net debt = Interest-bearing debt – Excess cash
Ratios of Success
By looking at these numbers, you may learn a lot about a company's ability to make a profit from its activities. Profitability ratios include profit margin, ROA, ROE, ROCE, and GM/COE.
Gross Profit Margin = Gross Profit / Net Sales
Ratios of Effectiveness
Efficiency ratios, often known as activity ratios, measure the effectiveness with which a business converts its resources into revenue. For example, inventory turnover is the most critical efficiency ratio. The formula for the efficiency ratio is bank expenses/net revenues. The inventory turnover ratio can be expressed as:
Inventory turnover ratio = Cost of goods sold * 2 / (Beginning inventory + Final inventory).
The Ratio of Coverage
Interest payment and other debt service coverage ratios indicate a company's financial health. Ratios such as debt-service coverage and interest-earnings multiples are examples.
Interest Coverage Ratio (ICR) = EBIT / Interest Expense
Comparisons of Market Prognosis Ratios
Many fundamental analysts rely on these ratios often. Dividend yield, price-to-earnings (P/E) ratio, EPS, and dividend payout ratio are all ratio analysis examples. In addition, investors use these measurements as guides for making long-term financial projections. Browse your net & get financial ratios formulas PDF with a ratio analysis formula list. The formula for coverage ratio is the market value per share/ book value per share.
Debt Ratio = Total Liabilities/Total Assets.
Conclusion
It is possible to utilise financial ratio analysis in two distinct but complementary contexts. First, you may use them to look at the previous quarter or years. In many cases, this is the first step in pinpointing the exact nature of the issue that requires attention. It may alert you to problems that you can prevent. Considering the ratio formula, you may also use these ratios to evaluate how well your business is doing compared to others in the same sector.
FAQs on Application of Percentage in Ratio Analysis: A Guide
1. What is ratio analysis and why is it important in commerce?
Ratio analysis is a quantitative method of gaining insights into a company's liquidity, operational efficiency, and profitability by studying its financial statements. It is important because it simplifies complex financial data, allowing for easier interpretation. This helps stakeholders like investors, creditors, and management make informed decisions by evaluating the company's performance over time and comparing it against industry benchmarks.
2. How are percentages specifically applied in ratio analysis?
Percentages are a primary way to express relationships between financial statement items in ratio analysis, making them easy to compare. Key applications include:
- Profitability Ratios: Ratios like the Gross Profit Ratio or Net Profit Ratio are expressed as a percentage of revenue, showing how much profit is generated for every rupee of sales.
- Common-Size Statements: In a common-size income statement, every item is shown as a percentage of total sales, revealing the proportion of costs to revenue.
- Trend Analysis: Calculating the percentage change in a ratio over several years helps identify patterns and predict future performance.
3. Can you give an example of calculating a profitability ratio using percentages?
Certainly. A key profitability ratio is the Net Profit Ratio. It is calculated to assess the overall profitability of the business. The formula is:
Net Profit Ratio = (Net Profit after Tax / Revenue from Operations) × 100
For instance, if a company has a Net Profit of ₹2,00,000 on Revenue from Operations of ₹10,00,000, its Net Profit Ratio would be (2,00,000 / 10,00,000) × 100 = 20%. This means the company earns 20 paise of net profit for every ₹1 of sales.
4. What are the main applications of ratio analysis for a business?
The applications of ratio analysis are wide-ranging and crucial for strategic management. Key uses include:
- Performance Evaluation: Assessing the firm's efficiency in areas like asset management and expense control.
- Financial Health Assessment: Determining the firm's ability to meet its short-term (liquidity) and long-term (solvency) obligations.
- Comparative Analysis: Benchmarking the firm's performance against competitors (inter-firm comparison) or its own past performance (intra-firm comparison).
- Decision Making: Providing a basis for management decisions related to budgeting, credit policies, and investment strategies.
5. Why is just calculating a financial ratio not enough for meaningful analysis?
Simply calculating a ratio provides a number, but not insight. Meaningful analysis requires interpretation and context. A single ratio is useless in isolation. For example, a Current Ratio of 2:1 seems good, but it must be compared with the industry average and the company's past ratios to determine if it truly reflects a healthy liquidity position. The 'why' behind the number—whether it's due to improved efficiency or a temporary fluke—is the most crucial part of the analysis.
6. What is the difference between expressing a ratio as a pure number (e.g., 2:1) versus a percentage (e.g., 50%)?
The way a ratio is expressed depends on what it is measuring.
- Pure Ratio (e.g., 2:1): Used for ratios comparing two distinct but related items, like the Current Ratio (Current Assets to Current Liabilities). It shows how many times one variable covers another.
- Percentage (e.g., 50%): Used when expressing a part-to-whole relationship, like the Gross Profit Ratio (Gross Profit as a part of Sales). It standardises the figure to a base of 100, making it intuitive for understanding profitability or composition.
- Times (e.g., 4 times): Typically used for turnover or activity ratios, like Inventory Turnover Ratio, to show the frequency of an activity during a period.
7. What are some common limitations or pitfalls to avoid when using ratio analysis?
While powerful, ratio analysis has limitations. A common pitfall is ignoring qualitative factors like management quality or economic conditions. Other limitations include:
- Historical Data: Ratios are based on past data and may not predict future performance accurately.
- Window Dressing: Companies might manipulate financial figures to present a better picture, distorting the ratios.
- Lack of Standardisation: Different accounting policies can make inter-firm comparison difficult.
- Price Level Changes: Inflation can distort financial data from different periods, affecting the comparability of ratios over time.
8. How does ratio analysis help in comparing a company's performance over time?
This process is known as trend analysis or time-series analysis. By calculating key ratios (like profitability or efficiency ratios) for a company over several consecutive years and plotting them on a graph or chart, an analyst can identify specific trends. For example, a consistently rising Net Profit Ratio indicates improving profitability, while a declining Debt-to-Equity ratio suggests a strengthening solvency position. This helps management understand the long-term trajectory of the company and take corrective actions if negative trends are spotted.
