Ratio analysis

Definition

Ratio analysis is a quantitative method of investigating the financial health of a company.
It involves comparing different financial figures and drawing conclusions about a company’s performance and financial situation.

Profitability Ratios

Profitability ratios measure a company’s ability to generate earnings.
This includes ratios such as gross profit ratio, net profit ratio, and return on capital employed.
Gross profit ratio indicates the percentage of revenue available to cover operating and other expenses.
Net profit ratio reveals the remaining profit after all costs and expenses are deducted.
Return on capital employed shows how effectively a company uses its capital.

Liquidity Ratios

Liquidity ratios assess a company’s ability to pay off its short-term debts.
Key liquidity ratios include the current ratio and the quick ratio, also known as the acid-test ratio.
Current ratio compares a company’s current assets to its current liabilities.
Quick ratio is a more stringent measure that excludes inventory from the current assets.

Efficiency Ratios

Efficiency ratios measure how well a company utilises its assets and liabilities.
Important efficiency ratios include inventory turnover ratio, creditor days, and debtor days.
Inventory turnover ratio indicates how often a company sells and replaces its inventory within a certain period.
Creditor days measures the average time the company takes to pay its creditors.
Debtor days calculates the average time the company takes to collect money from its customers.

Leverage Ratios

Leverage ratios are used to evaluate a company’s debt levels.
They include the debt ratio and equity ratio.
Debt ratio measures what proportion of a company’s assets are financed by debt.
Equity ratio analyses what proportion of a company’s assets are financed by shareholders’ equity.

Limitations of Ratio Analysis

Ratio analysis should be used with caution as it is based on historical financial data and may not accurately reflect a company’s future performance.
It is also important to compare ratios with those of similar companies in the same industry for a meaningful analysis.
Ratios can also be manipulated or distorted by different accounting policies and practices.