Ratio Analysis

Ratio analysis is a powerful and efficient tool in the world of Finance to assess a company’s financial performance, liquidity, solvency, profitability, and efficiency. It involves calculation and interpretation of various ratios which helps in evaluating the strengths, weaknesses, and overall financial health of a business.

Ratio analysis involves comparing different financial data points and creating relationships between them to gain meaningful business and financial insights.

The common ratios used in financial management can be categorised under the following heads:

1. Liquidity Ratios: Liquidity ratios measure a company’s ability to meet its short-term obligations and assess its liquidity position.
   • Current Ratio = Current Assets / Current Liabilities
   • Quick Ratio (Acid test) = (Current Assets – Inventory) / Current Liabilities
   • Receivables period in days = (Avg Receivables/Credit Sales)*365
   • Inventory days = (Avg Inventory/Cost of Sales)*365
   • Payables period in days = (Avg Payables/Purchases)*365
2. Solvency Ratios: Solvency ratios evaluate a company’s long-term financial stability and its ability to meet its long-term obligations.
   • Debt-to-Equity Ratio (DE ratio) = Debt / Equity
   • Gearing Ratio = Total Debt / (Debt+Equity)
   • Interest Coverage Ratio = EBIT / Interest Expense
   • Operating gearing = Contribution / EBIT
3. Profitability Ratios: Profitability ratios assess a company’s ability to generate profits and measure its overall financial performance.
   • Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue
   • Net Profit Margin = EBIT / Revenue
   • Return on Assets (ROA) = Net Income / Total Assets
   • Asset turnover = Revenue / Capital Employed
   • Return on Equity (ROE): Net Income / Equity
   • Return on Capital Employed (ROCE) = EBIT / Capital Employed
4. Efficiency Ratios: Efficiency ratios evaluate how effectively a company utilizes its assets and resources. They provide insights into inventory management, receivables turnover, and asset turnover.
   • Inventory Turnover Ratio = Cost of Goods Sold / Avg Inventory
   • Accounts Receivable Turnover = Net Credit Sales / Avg Accounts Receivable
   • Asset Turnover Ratio = Revenue / Avg Total Assets
5. Market Ratios: Market ratios evaluate the impact of company’s performance in the financial market which has a direct impact for shareholders.
   • Earnings per share (EPS) = Earnings available for distribution to equity / Number of shares issued and ranking for dividend
   • Price-to-Earnings Ratio (P/E) = Market Price per Share / Earnings per Share
   • Dividend Yield = Dividend per Share / Market Price per Share
   • Price-to-Book Ratio (P/B) = Market Price per Share / Book Value per Share
   • Total shareholders return (TSR) = ((Ending Share Price – Beginning Share Price) + Dividends) / Beginning Share Price

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Note:

• Contribution = Sales – variable cost
• Capital employed = Debt + Equity
• Debt = total long-term liabilities which are regarded as prior charge over equity capital
• Equity = shareholders fund which includes share capital, share premium and reserves
• ROCE = Net profit margin x asset turnover = (EBIT/Revenue) x (Revenue/capital employed)
• EBIT = Earnings Before Interest and Taxes = Operating profit

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These ratios provide valuable insights into the company’s performance, financial position, and efficiency in utilizing its resources. These are useful in benchmarking like compared with industry benchmarks or historical data to assess the company’s performance relative to its peers and over time.

Ratio analysis helps in identifying trends, potential risks, and areas for improvement, aiding in decision-making and financial planning. The new market ratios like TSR is most preferred currently towards measuring economic value add for shareholders as it is a comprehensive measure considering both stock price appreciation and dividend payout.

Some limitations of ratio analysis:

• Industry Differences: Different industries have distinct financial characteristics, making direct comparisons challenging. Ratios need to be interpreted in the context of the industry and company-specific factors.
• Data Quality: Ratios rely on accurate and reliable financial data. Inaccurate or manipulated financial statements can lead to misleading ratios.
• Limitations of Historical Data: Ratio analysis primarily uses historical financial data, which may not fully capture a company’s current or future performance and prospects.
• Lack of Context: Ratios provide numerical insights but may not capture the full qualitative aspects of a company’s operations or external factors affecting its financial performance.