Analyzing the financial performance of your company can help you understand where you have improved and where you have deteriorated. And we can analyze the financial performance of any company with the help of Ratio Analysis?
Ratio analysis also supports you in decision making for financial issues and problems. And with of interpretation of ratio analysis, the businesses can come to a clear conclusion on where to invest and where not to in the future.
This article will discuss the meaning, uses, and types of ratio analysis. This will give you a number of ways to analyze your business in an effective manner.
What is Ratio Analysis
Ratio Analysis is a method to understand the strengths and weaknesses of the financial status of any business. Ratio analysis involves the interpretation of various ratios to come to a decision.
Simple ratios cannot be helpful to determine the performance of your business. Several ratios that are appropriate must be used for analysis. Every analyst will have an objective to carry out any kind of analysis, based on these objectives the ratios are chosen.
Financial statements are tools for product math and financial management, but a layman cannot understand them. You need ratios to comprehend the quantitative data and come to a qualitative conclusion.
Definition of Ratio Analysis
The process of ratio analysis involves the comparison and examination of financial information of a business, using the figures of the financial statements.
Uses of Ratio Analysis
Ratio analysis of financial statements is used by financial institutions, banks, investors and a plethora of management sectors.
It helps them evaluate the performance in making investments, providing loans, getting credits, etc.
Decision Making and Forecasting
Analyzing the financial statements of a business can lead to an effective solution.
Ratio analysis is the key to making financial statement sharable. This leads to an enhanced understanding of all the stakeholders of the company. Using this information, a planning strategy is created. These ratios can help you draft meaningful conclusions in the future.
These conclusions guide you in enhancing the value of financial statements. It also helps the business communicate about its strengths and weaknesses. Interpretation of ratio puts the financial state of your business at ease.
This can support your business firm to decide on the future of the business. You can forecast about, where to invest? and, How to increase the revenue of the company? It makes planning very simple and effective.
Coordination and Control
Ratio analysis interpretation can improve the efficiency of the business by coordinating your team. This is essential in business to improve the effectiveness of management.
Good communication and coordination is always a plus point for businesses. This stops you from investing in something that may not be productive at all. Instead, it can give you better solutions to make your business strategy effective. Hence, it helps the business to stay in control of what is needed.
When ratios are analyzed. You can easily find deviations in a business. You can compare them to the actual position of the ratio and immediately find a solution to the problem.
Ratio analysis also discloses the weakness in the business. This can guide the business to move to a better position.
Better Financial Position
In any business, one can determine the number of ratios based on finance.
For example, there is a solvency ratio for a business that can assess its financial position. The probability ratios can determine the profitability of your firm. So you can easily decide whether you want to invest right now or after a few years.
You will know what will benefit your company in a big way.
Financial ratio analysis and interpretation can benefit your employees too. They can give suggestions to improve their salaries by analyzing profitability ratios. Thus, your reputation will increase and this puts you in a better financial position.
Ratios for a company or an institution are all based on both short-term and long-term financial positions. When analyzed properly, these can help you make better policies.
Usually, the lack of proper analysis leads to incomplete policies that may not work effectively. But ratio analysis can solve this major problem for your business.
Helps in Profit Analysis
Keeping an eye over assets and equity of your firm through the ratio analysis, a clear demarcation can be made between the profits and debts.
The estimated figure can also be obtained over the sum invested over every asset and about financial operations done over the investments. The degree of profit percentage can be measured and turned towards the favor of the firm.
Financial Risks Can Be Evaluated
The major significance of ratio analysis is that it can effectively measure the sensitivity towards the debts and assets of the company.
Through ratio analysis, a comparative figure can be predicted and the outstanding can be prevented.
Through the leverage ratio and equity ratio, a large number of financial risks can be outlined.
Ratio analysis presents the independent nature of the firm and mentions if the debts can be paid.
How Ratio Analysis Can Help You to Analyze Your Business
The best part about conducting a deep ratio analysis is to compare the performance with the previous years. Indeed it is important to know how each and every department in the business has evolved over the years. This is required to comprehend the present requirements of your firm and its departments.
You need to formulate more ideas to make the business better in every way. This method is highly effective in establishing future trends in your business.
The management and operations department in a company should be efficient as it can affect the utilization of assets over the years. These sectors of the business are essential to earning profits.
As a result, ratio analysis measures profitability, financial strength and sustain the liquidity of the company.
Types of Ratio Analysis
The process of analyzing ratios will totally depend upon the types of ratio analysis used for comparisons. You must wisely choose the ratio types so that it helps you in the future.
It also depends upon the type of business. Inventors, managers, employees use the operating performance ratio, risk ratio, growth ratio, and solvency ratio analysis.
This section will deal with all the different types of ratio analysis.
Furthermore, the list will also include a number of other sub ratio analysis types, such as types of financial ratios which will also be dealt with here.
Solvency Ratio Analysis
Solvency Ratio Analysis in accounting is divided into two types of ratios that are turnover ratio and liquidity ratio.
This ratio uses the receivables turnover ratio, days receivables, inventory turnover ratio, and days inventory. It also uses account payable turnover, days payable and cash conversion cycle.
This determines the number of sales done by the company when compared to the accounts received.
It involves the current ratio, quick ratio, and cash ratio. This is helpful in determining the ability of the company to cover its expenses.
It is especially useful in telling you how easily you can convert the assets of your company into cash (i.e., the liquidity). This ratio is usually compared with the liabilities of the company. Hence, balance sheet items calculate this ratio.
Operating Performance Ratio Analysis
The operating performance ratio analysis comprises the operating efficiency ratio and profitability ratio. This can determine the overall performance of the company based on its assets and its returns.
Operating Efficiency Ratio
This will include asset turn over ratio, net fixed asset turnover, and equity turnover ratio. This will follow a deep comparison between the total assets of your company along with the sales.
It combines the gross profit margin, operating profit margin, net profit margin, return on total assets, return on total equity, return on owner’s equity and DuPont ROE. This is calculated based on the total cost, sales, and profit. This is helpful in maintaining the expenses of the company.
Risk Ratio Analysis
Risks in a business can happen anytime due to various uncertainties. For risk analysis, a company looks into three types of risks. They are business risks, financial risks, and external liquidity risk.
This will include operating leverage, financial leverage, and total leverage. Risks can happen anywhere in the financial statement. Hence, only a proper ratio analysis interpretation can prevent the company from facing losses.
Financial Risks usually happen with the company taking loans from banks or partners. To prevent defaults happening in these cases, the leverage ratio, the DSCR ratio, and the interest coverage ratios are used.
External Liquidity Risks
These risks include the trading volume and bid-ask spread. You should analyze these factors so that your company understands the stock prices in a better way. Using the trade volume, you can also decide about the liquidity of the stocks of your company.
Growth Ratio Analysis
The growth rate is the major criterion to tell about your company’s development. When the company grows bigger, the growth rate should become more sustainable. Similarly, this factor will encourage your investors too. So this analysis includes sustainable growth analysis.
Sustainable Growth Analysis
To analyze sustainable growth factors like the rate of return on equity and the retention of earnings should be taken into account. This will help the investors to know about their future earnings as they invest. It also supports the valuation of your business.
Financial Leverage Ratios
Financial leverage ratio or debt ratio is equity or a measurable factor. Basically, the hierarchy of a company is quite risky regarding the capital. It can also be said that financial leverage ratios sum up the debt the company has to pay to correspond to the shares or assets. Differences in this financial leverage ratio generate two types of situations-
- When the stockholder owns the major share then the organization holds the tag of less leveraged.
- If the shares held by the creditors are in majority then the organization holds the tag of more leverage.
Too much of the debts are troublesome for the company as it will raise questions upon its financial operations. Financial leverage ratios are of two types –
It is a ratio that quantifies the extent of the assets of any company. It can also be estimated as the generalized ratio of assets to liabilities.
Through the debt ratios, the investors and stockholders can easily analyze the entire amount which they have to pay and also the extent of the company to pay the debt in the future. The debt ratio also throws light upon the fact that how many assets can be sold to meet the liabilities.
is a financial quantity which depicts the relatability between the company assets and finance required for it. The sum of liabilities and stockholders possession gives the exact value of assets.
Under the situation where a company earns higher on the assets rather than paying the debts, then a less equity ratio can be considered fruitful.
Market Prospect Ratios
Market prospect ratios are helpful for the evaluation of public sectors/ companies considering the deflation and inflammation with the stock prices. The stockholders and experts use this ratio so that they can make an estimate of the stock price and can easily figure out the value of assets.
Usually, investors make a huge bet upon this ratio as it is not an open fist.
Working Capital Ratio
In order to overcome or to avoid bankruptcy for the organization, the working capital ratio can be very useful. It quantifies the potential of the company to increase its turnover and grow. Two of the most affecting factors in the working capital ratio are-
- If the ratio of assets to liabilities is below 1 then the company has less working capital ratio.
- If the company has the highest working capital then it is also considered a negative thing.
This tells us about the importance of ratio analysis that makes a company or your business strong. It drafts a clear evaluation of what to focus on, in the present and how to improve these metrics for the future.
Ratio analysis is helpful in learning about your own company from every perspective. It is the clubbing of ratios that helps you make good decisions, as it reduces any biases owing to the use of only a single ratio.
Any single metric cannot be sufficient to decode your financial statements. Hence, this is the most reliable method to carry out the financial analysis.
Now that you have been introduced to the basics of ratio analysis, you may have some queries to clarify. We can help you with them in the comment section. We will be pleased to hear your comments and to clear your doubts.