Definition of Ratio Analysis

Ratio Analysis: This is a financial method utilised by organisations to evaluate their performance and financial condition.
The process involves comparing different financial figures, taken from the balance sheet, income statement, and cash flow statement, to gain a full understanding of a company’s economic health.
Ratio analysis allows the comparison of a company’s financial performance with that of other companies in the same industry.

Types of Ratio

Profitability Ratios: These ratios measure the ability of a company to generate earnings compared to its costs and other expenses incurred during a specific period. Key ratios include gross profit margin, operating profit margin, and net profit margin.
Liquidity Ratios: These ratios measure a company’s ability to repay both short- and long-term obligations. Important measures include current ratio and quick ratio.
Efficiency Ratios: These ratios measure how effectively a company uses its assets and manages its liabilities. Inventory turnover and asset turnover ratio are significant efficiency ratios.
Leverage Ratios: These ratios measure the extent of a company’s reliance on debt financing. Debt ratio and equity ratio are two key leverage ratios.

Interpreting Ratios: A single ratio on its own does not provide sufficient detail or insight. The value lies in comparing ratios over different periods or against other companies or industry standards.
Benchmarking: Ratios can be compared to benchmarks such as industry averages or competitor ratios to determine the relative performance.
Trend Analysis: Comparing a company’s current ratios with its past ratios helps identify trends and determine financial progress over time.

Strategic Decision Making: Ratio analysis helps in strategic decision making by providing vital information about the company’s profitability, liquidity, efficiency, and financial stability.
Investor Analysis: Investors use ratio analysis to evaluate a company’s financial position and make investment decisions.
Limitations: Ratios only provide a broad overview and do not consider qualitative factors such as management quality, market conditions, or legal considerations. Disclaimer: There is also the risk of manipulation of figures by organisations. Therefore, ratios should always be used in conjunction with other assessment methods.

Interpreting Ratios: While computing ratios is relatively straightforward, interpreting them requires in-depth business, financial, and industry knowledge. It is also essential to understand the inter-relationships among the different ratios and financial statement numbers.
Continuous Monitoring: Regular monitoring of ratios over time is necessary to spot trends, positive or negative, and take appropriate action.
Conducting Ratio Analysis: Always look at series of ratios rather than single ratio. Use industry averages as benchmark, and analyse trends to make conclusive decisions.