Ratio Analysis

SECTION 1: UNDERSTANDING RATIO ANALYSIS

  • Ratio Analysis is a quantitative method of gaining insights into a company’s liquidity, operational efficiency, and profitability by studying its financial statements.
  • It involves comparing different figures from the balance sheet, income statement, and cash flow statement, to project the future financial performance of a company.
  • Ratio analysis not only helps in decision-making but also in forecasting and planning.

SECTION 2: TYPES OF RATIOS USED IN ANALYSIS

  • Profitability ratios: These measure the ability of a company to generate earnings relative to sales, assets, and equity. Examples include Gross Profit Ratio, Return on Assets, and Return on Equity.
  • Liquidity ratios: These measure the ability of a company to meet its short-term obligations. Examples are Current Ratios and Quick Ratios, also known as Acid-Test Ratios.
  • Efficiency ratios: These measure how efficiently a company uses its assets and manages its liabilities. Inventory Turnover and Asset Turnover are examples.
  • Solvency ratios: These measure a company’s ability to sustain operations in the long term by comparing debt levels with equity, assets or earnings. Debt to Equity Ratio and Equity Ratio are examples.

SECTION 3: IMPORTANCE OF RATIO ANALYSIS

  • Benchmarking and Performance Analysis: Ratios can be used to compare a company’s performance with that of other companies in the same industry, or evaluate the trends in that company’s performance over time.
  • Investment Decisions: Ratio analysis helps investors and management to understand where the company stands in terms of financial health, which aids the decision-making process.
  • Identify Problem Areas: By studying various ratios, a company can identify its weaknesses and take necessary measures to improve.

SECTION 4: LIMITATIONS OF RATIO ANALYSIS

  • Lack of Comparability: Business practices differ from company to company. They can render the comparison of ratios between different companies or industries misleading.
  • Historic Information: Ratios are calculated on the basis of past financial information, and may not reflect the company’s current or future financial position.
  • Inflation Distortion: Changes in price levels can distort the results of the ratio analysis.

SECTION 5: KEY RATIOS AND THEIR INTERPRETATIONS

  • Current Ratio: A measure of a company’s ability to cover its short-term liabilities with its short-term assets. A ratio greater than 1 implies good financial health.
  • Debt to Equity Ratio: Measures the financial leverage of a company. A lower ratio is more favourable, implying the company is less reliant on external borrowing.
  • Gross Profit Margin: Reflects profitability relative to direct costs. Higher ratios indicate the business has cushion to withstand difficult economic times.
  • Return on Equity: Measures the profits generated from shareholders’ investments. A higher ratio indicates better utilisation of shareholder funds.