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Ratio Analysis
Financial ratios are the most important metric for any organization to understand its performance and to assist analysts in analyzing the industry. It is used to create some meaningful insights by taking the numbers from the company’s financial statements, which are the balance sheet, income statement, and cash flow statement.
It represents an overview of the companies based on the 4 key indicators:
1. Liquidity
2. Activity, Performance, Turnover, or Efficiency
3. Profitability
4. Solvency or leverage
1. Liquidity Ratios
These ratios demonstrate the company's ability to pay its short-term liabilities. It helps to determine whether a company has enough current assets, liquid assets, or cash and cash equivalents to cover its current liabilities.
There are three ratios used to determine the short term liquidity position of the companies: the current ratio, quick or acid test ratio, and cash ratio.
Current Ratio
This ratio indicates how many times a company's current assets can be used to repay its current liabilities.
Current Ratio = Current Assets / Current Liabilities
Quick or Acid Test Ratio
This ratio indicates that the company has sufficient quick assets to cover its current liabilities.
Quick or Acid Test Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
Cash Ratio
This ratio implies how many times a company has enough cash and marketable securities to repay its current liabilities.
1. Liquidity
2. Activity, Performance, Turnover, or Efficiency
3. Profitability
4. Solvency or leverage
1. Liquidity Ratios
These ratios demonstrate the company's ability to pay its short-term liabilities. It helps to determine whether a company has enough current assets, liquid assets, or cash and cash equivalents to cover its current liabilities.
There are three ratios used to determine the short term liquidity position of the companies: the current ratio, quick or acid test ratio, and cash ratio.
Current Ratio
This ratio indicates how many times a company's current assets can be used to repay its current liabilities.
Current Ratio = Current Assets / Current Liabilities
Quick or Acid Test Ratio
This ratio indicates that the company has sufficient quick assets to cover its current liabilities.
Quick or Acid Test Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
Cash Ratio
This ratio implies how many times a company has enough cash and marketable securities to repay its current liabilities.
Cash Ratio = Cash and Cash Equivalents / Current Liabilities
2. Activity, Performance, Turnover, or Efficiency Ratios
Performance is the biggest factor for every organization's success in their businesses. This ratio helps us to understand how effectively a company uses its assets and resources to generate revenue by utilizing them.
Commonly used activity, performance, turnover, or efficiency ratios are as follows:
Asset Turnover Ratio
This ratio implies the company’s ability to generate revenue by utilizing its assets.
Asset Turnover Ratio = Net Sales / Total Assets
Where,
Net sales = Sales – Sales Return
Current Asset Turnover Ratio
This ratio implies the company’s ability to generate revenue by utilizing its current assets.
Current Asset Turnover Ratio = Net Sales / Current Assets
Working Capital Turnover Ratio
This ratio indicates how well a company uses its working capital to generate revenue.
Working Capital Turnover Ratio = Net Sales / Working Capital
Where,
Working Capital = Current Assets – Current Liabilities
Stock or Inventory Turnover Ratio
This ratio implies how many times a company has sold its inventories and replaced them over a given time period.
Stock or Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory
Where,
Cost of Goods sold (COGS) = Net Sales – Gross Profit
or
Cost of Goods Sold (COGS) = Opening Stock + Purchase + Direct Expenses – Closing Stock
Average Stock or Inventory = (Opening Stock + Closing Stock) / 2
Debtors or Receivables Turnover Ratio
This ratio implies how many times the company converts its debtors into cash and cash equivalents over the given period of time.
Receivables or Debtors Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Where,
Net Credit Sales = Net Sales – Cash Sales
Average Accounts Receivables = (Opening Debtors and Bills Receivable + Closing Debtors and Bills Receivable) / 2
Payables or Creditors Turnover Ratio
This ratio implies how many times the company pays its creditors in cash and cash equivalents over a period of time.
Payables or Creditors Turnover Ratio = Net Credit Purchase / Average Accounts Payable
Where,
Net Credit Purchase = Net Purchase – Cash Purchase
Average Accounts Payables = (Opening Creditors and Bills Payable + Closing Creditors and Bills Payable) / 2
3. Profitability Ratios
Profitability is one of the most important aspects of any business; without sufficient profits, a company cannot survive in the long run. We analyze the firm’s ability to generate profits relative to its revenue, operating costs, balance sheet assets, and equity. Profitability ratios that are commonly used are as follows:
Gross Profit or Gross Margin Ratio
This ratio implies the efficiency of the company's core business performance. This helps us understand how much revenue, in percentage terms, a company generates after paying its cost of goods sold.
Gross Profit or Gross Margin Ratio = Gross Profit / Net Sales
Where,
Gross Profit = Net Sales – Cost of Goods sold + Direct Expenses
Net Profit or Net Margin Ratio
This ratio indicates how much profit, in percentage terms, a company earns after deducting all of its expenses.
Net Profit or Net Margin Ratio = Net Profit / Net Sales
Operating Profit or Operating Margin Ratio
This ratio denotes how much a company earns as a percentage of its net sales by comparing operating income to net sales to assess the business's operating efficiency.
Operating Profit or Operating Margin Ratio = Operating Profit / Net Sales
Where,
Operating Profit = Earnings before Interest and Taxes (EBIT)
Return on Equity Ratio
This ratio implies how a company utilizes its equity to generate optimum profit.
Return on Equity Ratio = Net Income / Share Holder’s Equity
Where,
Shareholder’s Equity = Equity Share Capital + Preferential Share Capital + Retained Earnings
Return on Assets Ratio
This ratio implies how well a company utilizes its assets to generate optimum profit.
Return on Assets Ratio = Net Income / Total Assets
4. Solvency or Leverage Ratios
Leverage or solvency ratios check the amount of capital that comes from borrowed funds or in the form of debt. This helps us to evaluate the long term solvency level of the company. Commonly used solvency or leverage ratios are as follows:
Debt to Equity Ratio
This ratio implies the proportion of debt against the equity shareholders of the company.
Debt to Equity Ratio = Debt / Equity
Where,
Debt = Long term loans + Debentures
Equity = Shareholders Funds
Total Assets to Debt Ratio
This ratio implies how many times a company's total assets exceed its long-term debt.
Total Assets to Debt Ratio = Total Assets / Debt
Proprietary Ratio
This ratio implies how much a portion of the company's total assets comes from shareholder funds.
Proprietary Ratio = Shareholders Fund or Proprietor Funds or Equity / Total Assets
Interest Coverage Ratio
This ratio implies how many times a company earns compared to its interest on long-term debt obligations.
Interest Coverage Ratio = Profit or Income before interest, tax and dividend (EBIT) / Interest on long-term loans or debentures
Capital Gearing Ratio
This ratio implies how many times a company has equity from shareholders against its long-term debt and preferential capital.
Capital Gearing Ratio = (Debentures + Preference Capital + Loans) / Equity
Where,
Equity = Equity share capital + Reserves and Surplus
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