Ratio Analysis
Ratio analysis is a fundamental technique in financial statement analysis that involves calculating and interpreting various financial ratios to evaluate a company’s financial performance, liquidity, solvency, efficiency, and profitability. These ratios are computed by comparing different items in a company’s financial statements, such as the income statement and the balance sheet. Ratio analysis helps stakeholders, including investors, creditors, and management, gain insights into a company’s financial health and make informed decisions. Here are some commonly used financial ratios and their significance:
1. Liquidity Ratios:
– Current Ratio:
Current assets divided by current liabilities. It assesses a company’s ability to meet short-term obligations. A ratio above 1 indicates liquidity.
– Quick Ratio (Acid-Test Ratio):
(Current assets – Inventory) divided by current liabilities. It provides a more stringent measure of liquidity, excluding less liquid assets like inventory.
2. Profitability Ratios:
– Gross Profit Margin:
(Gross Profit / Revenue) × 100. It measures the percentage of revenue retained as gross profit after covering the cost of goods sold.
– Net Profit Margin:
(Net Profit / Revenue) × 100. It assesses the percentage of revenue that remains as net profit after all expenses, including taxes and interest.
– Return on Assets (ROA):
(Net Profit / Total Assets) × 100. It indicates how efficiently a company utilizes its assets to generate profit.
– Return on Equity (ROE):
(Net Profit / Shareholders’ Equity) × 100. It measures the return on shareholders’ investment in the company.
3. Solvency Ratios:
– Debt to Equity Ratio:
Total Debt / Shareholders’ Equity. It assesses the proportion of financing provided by debt compared to equity. A lower ratio indicates lower financial risk.
– Interest Coverage Ratio:
Earnings Before Interest and Taxes (EBIT) / Interest Expense. It evaluates a company’s ability to meet interest payments on its debt.
– Debt Ratio:
Total Debt / Total Assets. It measures the proportion of assets financed by debt.
4. Efficiency Ratios:
– Inventory Turnover:
Cost of Goods Sold / Average Inventory. It indicates how efficiently a company manages its inventory.
– Accounts Receivable Turnover:
Net Credit Sales / Average Accounts Receivable. It assesses how quickly a company collects payments from customers.
– Asset Turnover:
Revenue / Average Total Assets. It measures how efficiently a company uses its assets to generate revenue.
5. Market Ratios:
– Price-to-Earnings (P/E) Ratio:
Market Price per Share / Earnings per Share (EPS). It helps investors gauge the market’s expectations of a company’s future earnings growth.
– Price-to-Sales (P/S) Ratio:
Market Price per Share / Sales per Share. It assesses the stock’s price relative to the company’s revenue.
– Dividend Yield:
Dividend per Share / Market Price per Share. It calculates the return an investor can expect from dividend payments.
6. Coverage Ratios:
– Dividend Coverage Ratio:
(Earnings Available for Dividends / Total Dividends) × 100. It measures a company’s ability to cover dividend payments with its earnings.
– Times Interest Earned (TIE) Ratio:
EBIT / Interest Expense. It indicates how well a company can cover its interest payments.
Ratio analysis is a valuable tool for financial statement analysis because it provides a concise and standardized way to evaluate a company’s financial performance over time and in comparison to its peers or industry benchmarks. However, it’s essential to consider ratios in the context of the company’s industry, business model, and economic conditions to draw meaningful conclusions.