What role does ratio analysis play for analysing a company?
Ratio analysis is the analysis of various parts of financial information in the financial statements of the company. It is mainly used by external analysts to analyse a company based on its profitability, liquidity & solvency. Nowadays, determining the financial health of a company is considered a crucial part of fundamental analysis. This fundamental analysis is done for various reasons, ranging from making an investment into any company to merging or acquiring any company, etc. Both the current as well as the past data are used by the analysts to analyse the financial health of the company, whether it’s upward or downward, and also, helps to compare the company with its peers based on the performance.
Below are some of the advantages of ratio analysis:
Ratio analysis helps to understand where do the company stands in the market as compared to its peers. This also helps the management to identify gaps and do a SWOT analysis of the company i.e. strength, weaknesses, opportunities, and threats. The management can then formulate decisions, accordingly, based on the information gathered from the ratio analysis.
2) Trend line:
The company can use ratio analysis to identify if any trend has been established for the financial performance of the company. The established companies gather data over a large number of reporting periods. The future financial performance of the company can be predicted using ratio analysis and also where any forthcoming financial turbulence is sensed.
3) Operational efficiency:
The ratio analysis is also used by the management the degree of efficiency in the management of assets and liabilities. The over-utilisation and underutilisation of financial resources can also be monitored using the financial ratio analysis.
The financial ratios can be categorised into the following categories: -
1) Liquidity ratios
Liquidity ratios basically measure a company’s ability to meet its debt obligations using its current assets. Current assets are all the assets of a company that are expected to be sold or used as a result of standard business operations over the next year. At the time of financial difficulties, the company converts its assets into cash and settles the pending debts using the cash generated. Some of the common liquidity ratios are:
Where current assets = cash, cash equivalents, accounts receivable, stock inventory, marketable securities, pre-paid liabilities & other liquid assets while current liabilities= accounts payable, short-term debt, dividends, and notes payable, as well as income taxes, owed.
Where quick assets = cash & equivalents + marketable securities + accounts receivables
2) Solvency ratios
Solvency ratios are used to measure a company’s long-term viability. While using the solvency ratios, the company’s debt levels are compared to its assets, equity, or annual earnings. These ratios are primarily used by governments, banks, employees, and institutional investors. The important solvency ratios are:
This ratio helps to determine the company’s risk level.
This ratio helps in understanding the financial structure of the company and whether it is a good investment or not. Higher the ratio, the riskier the investment.
Where EBIT = earnings before interest & taxes .
This ratio tells the company’s ability to easily pay interest from the generated EBIT. The higher the ratio, the better is the position of the company.
This ratio measures the number of a firm’s assets that are financed by its shareholders. In other words, it also shows how much debt financing the company has used to acquire assets and maintain operations. It is an indication of the company’s risk to the creditors.
3) Profitability ratios
Profitability ratios measure the ability of businesses to earn profits in comparison to their associated expenses. A higher profitability ratio as compared to past periods can portray that the business is improving financially. Examples of profitability ratios include:
ROE measures the profitability of the organisation in relation to the stockholder’s equity.
ROA tells how profitable the company is as compared to its total assets.
Higher the ratio, the better the performance of the company.
Capital employed is calculated as (total assets – current liabilities) i.e., the total amount of equity invested in the business. This ratio tells us how efficiently the company is using its capital to generate profits.
4) Efficiency ratios
Efficiency ratios tell us how well the business is using assets & liabilities to generate its sales and earn profits. Some important efficiency ratios are:
The ratio helps in understanding how effectively assets are used in generating sales.
Inventory turnover measures how many times in a given period a company is able to replace the inventories that it has sold.
This is an important ratio in understanding how effectively the company is managing its payables and suppliers.
Working capital turnover depicts how effective a business is at generating sales for every dollar of working capital put to use.
5) Coverage ratios
Coverage ratios throw light on the company’s ability to service its debts and other obligations. A higher coverage ratio displays that a business can service its debts and associated obligations with better ease. Following is the important coverage ratios:
DSCR is the measurement of a firm's available cash flow to pay current debt obligations.
Where, EBIT = Earnings before interest & taxes and
FCBT= Fixed charges before taxes
FCCR tells us regarding the firm's ability to cover its fixed charges, such as debt payments, interest expense, and equipment lease expense.
Where, EBITDA = Earnings before interest, depreciation & taxes
EBITDA coverage ratio studies the ability of a company's EBITDA to pay annual financial obligations.
6) Market prospect ratios
Market prospect ratios assist investors in predicting how much they will earn from specific investments. The earnings can take the form of higher stock value or future dividends. The key market prospect ratios are:
Historical evidence suggests that focus on dividends may expand returns rather than slow them down.
EPS indicates the profitability of the company and hence is considered a crucial indicator.
PE ratio shows what the market is willing to pay for a company’s profits. It helps to conclude if the share is overvalued or undervalued.
The dividend payout ratio helps the investors in knowing the dividend sustainability of a company.