Ratio Analysis: A Comprehensive Guide

In simplest terms, ratio analysis is a procedure that individuals use to determine an organisation’s financial condition and well-being. Through this process, accountants learn about a company’s ability to make profits, and its efficiency in business operations. In addition, investors can also gather data on liquidity of a company’s assets to meet its working capital requirements. 

Besides, one can form an idea about a corporation’s performance in a competitive sector using this method. Therefore, ratio analysis presents a detailed insight into a company’s ability to compete with similar organisations in an industry or a sector.

However, there are several ratio analysis advantages and disadvantages that students must keep in mind. Learning the definition of ratio analysis and its limitations therefore would help them understand the concept better.

What is Ratio Analysis? 

By its definition, ratio analysis is a process to scrutinise and compare financial data of a company using its financial statements. This method actively uses the data from financial statements to calculate the financial health and performance of a company. Therefore, this process eliminates the need of analysing and comparing line items from each financial statement. 

This prevailing method primarily helps the management of a company as well as its investors to gather information on its growth percentage. Besides, this method also clarifies the operational drawbacks of an organisation. As a result, the management can take suggestions from the ratio analysis to take the right course of financial action. Thereby, a company benefits largely from this widely prominent method. 

For example, let’s consider that a company XYZ has had an annual income of Rs. 1,00,000. On the other hand, the cost of XYZ is around Rs.60,000. Therefore, the margin of profit for XYZ is Rs.40,000. As a result, the ratio analysis suggests that the gross profit is 40% of the revenue of XYZ.

Consequently, the margin of profit of XYZ is denoted by a percentage instead of line comparison of financial statements. However, there are several types of ratio analysis that companies use to gather data on their financial operations. Having knowledge about these types will certainly help a student understand the advantages and limitations of ratio analysis.

Ratio Analysis Formulas

• Liquidity Ratios:

• Current Ratio = Current Assets / Current Liabilities

• Quick Ratio = (Current Assets - Inventory) / Current Liabilities

• Profitability Ratios:

• Gross Profit Margin = (Gross Profit / Revenue) x 100

• Net Profit Margin = (Net Profit / Revenue) x 100

• Return on Assets (ROA) = Net Income / Total Assets

• Return on Equity (ROE) = Net Income / Shareholder’s Equity

• Efficiency Ratios:

• Asset Turnover Ratio = Revenue / Total Assets

• Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

• Receivables Turnover Ratio = Revenue / Average Accounts Receivable

• Leverage Ratios:

• Debt-to-Equity Ratio = Total Debt / Shareholders’ Equity

• Debt Ratio = Total Debt / Total Assets

• Market Ratios:

• Earnings Per Share (EPS) = Net Income / Number of Outstanding Shares

• Price-to-Earnings (P/E) Ratio = Market Price per Share / Earnings per Share

What are the Types of Ratio Analysis? 

Companies use a wide array of ratio analysis types to understand the financial condition and position within a sector. As a result, they can gather effective information on the level of cash flow circulating within the organisation. Therefore, these types of ratio analysis helps an investor know about an institution’s solvency, profitability, and asset liquidity. 

Moreover, the fundamental classification of ratio analysis include the following –

• Activity Ratio Analysis – Activity ratio analysis implies the assessment of a company’s efficiency and scale of operations. This method helps accountants understand the pace at which companies convert their inventories into sales. Besides, this method also helps them to understand how the cash from sales helps them to manage their fixed capital and working capital. Activity ratio analysis also includes inventory turnover ratio, working capital turnover ratio, and payables turnover ratio among others. 

• Profitability Ratio Analysis – This category of ratio analysis helps a business measure its profits. As a result, accountants can use the profitability ratio analysis to determine the company’s ability to bag profits. Besides, this works as a marker for the industry to understand which companies have exhibited the most profits. Therefore, it duly conveys the financial health of an organisation. This kind of analysis takes into account the net profit margin, gross profit margin, and return on capital employed. 

• Liquidity Ratio Analysis – This method duly analyses an organisation’s liquidity of its assets. Therefore, individuals can gather an idea about the rate at which the company can convert its assets into cash. This procedure is mainly used to determine a company’s ability to fulfil its financial obligations without experiencing any disruption. 

• Solvency Ratio Analysis – Solvency ratio analysis takes into account the long-term financial sustainability of a business. Therefore, it is used to analyse the ability of an organisation for paying off its long-term financial obligations. These obligations thus include loans taken from financial institutions to fund its capital requirement, and the bonds it has issued in the secondary market. 

These are the main types of ratio analysis that companies use to understand their financial position, performance, and health. Now it’s time to move on to the advantages and disadvantages of the ratio analysis process.

What are the Steps of Ratio Analysis?

The major steps involved in ratio analysis are collecting relevant accounting data from financial statements, constructing ratios of related accounting figures, comparing the constructed ratios with standard ratios (corresponding ratios of the past, average ratios of the firm and ratios of the competitors) and finally the interpretation of ratios in order to arrive at certain valid conclusions.

What are the Objectives of Performing Ratio Analysis?

Ratio analysis is a very important tool for financial analysis and management in order to interpret the financial statements and data of a company. The major objectives of ratio analysis are to measure the profitability of a company improve on the areas which are weak or at loss, evaluate the degree of efficiency of a company, to ensure liquidity, that is, the required level of short-term solvency, to diagnose the overall financial strength that determines the long-term solvency of a company and to compare a company with its existing competitors in the market.

What are the Advantages of Ratio Analysis? 

The most prevailing advantages of ratio analysis are as follows – 

• Ratio analysis effectively directs a company’s operational decisions on the basis of its percentage value. As a result, companies can either encourage or discourage a managerial policy depending on the value that ratio analysis has denoted. On top of that, ratio analysis simplifies the figures in a financial statement into simplified ratios and percentages. This in turn enables organisations to take swift decisions to improve their financial status. 

• Ratio analysis actively opens decision making avenues by considering the drawbacks and strengths of operations. Since ratio analysis also indicates the growth factor of an organisation, it brings several operational areas under the lens of management. As a result, the decision making entities within a company can determine the drawbacks of that company accurately. 

• Ratio analysis additionally provides an insight into an organisation’s performance within its industry. Besides, this process also helps a company determine its position in the associated sector. Therefore, companies implement the ratio analysis method to find ways to outdo their competitors in the market. 

As the advantages of ratio analysis have been discussed, let’s shift our focus to the ratio analysis limitations.

What are the Disadvantages of Ratio Analysis? 

The limitations of ratio analysis include the following pointers – 

• The primary limitation of ratio analysis is that it is a process and not a solution in itself. This process lacks a value of its own unless decision makers use this to take effective directions. 

• The methods of ratio analysis differ for various companies. Therefore, due to the lack of uniformity in the process, the data gathered are often incompatible. For example, certain firms may or may not consider current liabilities in the process of calculating their current ratio. 

• One of the major disadvantages of ratio analysis is that it considers only the monetary inclinations of a business. Therefore, it blatantly ignores the qualitative aspects of a firm such as productivity and working conditions of the employees.

The above mentioned points are the fundamental disadvantages of the ratio analysis method. Students are now aware of both the advantages and disadvantages of ratio analysis methods. Therefore, they can determine whether a company should use this method or eliminate it from their financial accounting procedure.