The term ratio analysis consists of two terms I.e. ratio and analysis. Ratio means numerical relationship between two accounting figures or values. Analysis means examination and interpretation.
ratio analysis definition – ratio analysis means examination and interpretation of numerical relationship of two values.
The relationship between two accounting figures can be expressed in different mathematical forms like percentage, number of times, ratio form, etc. Ratio analysis is widely used tool of financial analysis. It enables the users to measure the performance of the business. It facilitates inter-firm as well as intra firm comparison.
- Ratio Analysis Key point
- Main objectives of ratio analysis are as follows
- Types of Ratios analysis
Ratio Analysis Key point
- Relationship between two figures expressed in arithmetical terms is called a ratio.
- Relationship between two or more variables.
- Ratio analysis can mark how a company is performing over time, while comparing a company to another within the same industry or sector.
- While ratios offer useful insight into a company, they should be paired with other metrics, to obtain a broader picture of a company’s financial health
- Ratio analysis compares line-item data from a company’s financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency.
- Short term solvency – It includes 3 ratio’s 1-current ratio. 2-liquid ratio. 3-working capital ratio.
- Current ratio shows relationship between current assets and current liabilities.
- Its ideal ratio 2:1
- It is susceptible to window dressing
- Current ratio = current assets/ current liabilities
- Acid test/ quick ratio / liquid ratio – whether the firm is in a position to pay its current liabilities within a month or immediately.
- Most rigorous test of liquidity
- Ideal ratio 1:1
- Quick ratio = liquid assets/ current liabilities
- Liquid assets include all current assets except stock and prepaid expenses.
- Net working capital ratio = current assets – currents liabilities
Main objectives of ratio analysis are as follows
- Measure of Profitability
- Evaluation of Operational Efficiency
- Ensure Suitable Liquidity
- Overall Financial Strength
Types of Ratios analysis
There are actually two ways in which financial ratios can be classified. There is the classical approach, where ratios are classified on the basis of the accounting statement from where they are obtained. The other is a more functional classification, based on the uses of the ratios and the purpose for which they are calculated.
[A] Traditional Classification
1] Profit and Loss Ratios
When both figures are derived from the statement of Profit and Loss A/c we will call it a Profit and Loss Ratio. It can also be known as Income Statement Ratio or Revenue Statement Ratio. One such example is the Gross Profit ratio, which is the ratio of Gross Profit to Sales or Revenue. As you will notice, both these amounts will be derived from the Profit and Loss A/c. Other examples include Operating ratio, Net Profit ratio, Stock Turnover Ratio etc.
2] Balance Sheet Ratios
Just as above, if both the variables are obtained from the balance sheets, it is known as a balance sheet ratio. When such a ratio expresses the relation between two accounts of the balance sheet, we also call them financial ratios (other than accounting ratios).
Take for example Current ratio that compares current assets to current liabilities, both derived from the balance sheet. Other examples include Quick Ratio, Capital Gearing Ratio, Debt-Equity ratio, etc.
3] Composite Ratios
A composite ratio or combined ratio compares two variables from two different accounts. One is taken from the Profit and Loss A/c and the other from the Balance Sheet. For example the ratio of Return on Capital Employed. The profit (return) figure will be obtained from the Income Statement and the Capital Employed is seen in the Balance Sheet. A few other examples are Debtors Turnover Ratio, Creditors Turnover ratio, Earnings Per Share etc.
Click here to see Formula: Accounting Ratios with Formula
[B] Functional Classification
Then we move onto the functional classification. These help us group the ratios according to the functions they perform in our understanding and analysis of financial statements. This is a more accurate and useful classification of ratios, and hence more commonly used as well. The types of ratios according to the functional classification are
1] Liquidity Ratios
A firm needs to keep some level of liquidity, so stakeholders can be paid when they are due. All assets of the firm cannot be tied up, a firm must look after its short-term liquidity. These ratios help determine such liquidity, so the firm may rectify any problems. The two main liquidity ratios are Current Ratio and Quick Ratio (or liquid ratio).
Click here to see Formula: Liquidity Ratio
2] Leverage Ratios
These ratios determine the company’s ability to pay off its long-term debt. So they show the relationship between the owner’s fund and the debt of the company. They actually show the long-term solvency of a firm, whether it has enough assets to pay of all its stakeholders, as well as all debt on the Balance Sheet. This is why they are also called Solvency ratios. Some examples are Debt Ratio, Debt-Equity Ratio, Capital Gearing ratio, etc.
Click here to see Formula: Leverage Ratios
3] Activity Ratios / Efficiency Ratio
Activity ratios help measure the efficiency of the organization. They help quantify the effectiveness of the utilization of the resources that a company has. They show the relationship between sales and assets of the company. These types of ratios are alternatively known as performance ratios or turnover ratios. Some ratios like Stock Turnover, Debtors turnover, Stock to Working Capital ratio, etc measure the performance of a company.
Click here to see Formula: Activity Ratios
4] Profitability Ratios
These ratios analyze the profits earned by an entity. They compare the profits to revenue or funds employed or assets of an entity. These ratios reflect on the entity’s ability to earn reasonable returns with respect to the capital employed. They even check the soundness of the investment policies and decisions. Examples will include Operating Profit ratio, Gross Profit Ratio, Return on Equity Ratio, etc.
Click here to see Formula: Profitability Ratios
5] Coverage Ratios
Shows the equation between profit in hand and the claims of outside stakeholders. These are stakeholders that are required by the law to be paid, even in case of liquidation. So these types of ratios ensure that there is enough to cover these payments to such outsiders. Some examples of coverage ratios are Dividend Payout Ratio, Debt Service ratio, etc.
Click here to see Formula: Coverage Ratios