Home » Learn » Share Market » Exploring the depths: Types of ratio analysis

Exploring the depths: Types of ratio analysis

Financial statements of all businesses are prepared to show their performance and ratio analysis is an integral part of it. Different tools are utilized to evaluate the performance of the company and one such analysis tool is ratio analysis.

In this article, we will look at how ratio analysis, a quantitative approach in the preparation of financial statements, is important. Additionally, we will also look at the different types of ratio analysis with examples for an in-depth understanding.

What is ratio analysis?

The liquidity, profitability and operational efficiency of a business can be understood by looking at its financial statements. Equity research is greatly dependent on the ratio analysis as it accounts for all factors such as liquidity, debt, profitability, and activity during financial analysis.

The ratio analysis is a valuable tool that helps analyse the performance of the company from a variety of lenses. As a result, the process of comparing various things in the business’s financial statements is referred to as ratio analysis.

5 types of ratio analysis

The different types of ratio analysis help look at the different aspects of a business’s financial health such as debt coverage and asset use. One financial ratio analysis covers only one aspect of a business which necessitates looking at distinct ratios at once.

Additionally, since the data and ratios vary over time it is integral to compare them across time frames.

Here are the different types of ratio analysis with formulas broadly categorised into 5 groups:

1. Leverage ratios

Also known as solvency ratios, these ratios are a type of ratio analysis that provides valuable information on a company’s ability to pay for its loans in the long term.

It gives an insight into the company’s reliance on debt to finance its everyday operations as well as the ability to meet its obligations. Some of the most common leverage ratio analysis formulas include:

• Debt-to-equity ratio: It compares the royal debt of the company to the capital that is provided by investors.

Debt to Equity Ratios = Total Liabilities / Total Shareholders’ Equity

• Debt ratio: This ratio compares the company’s total debts to its total assets.

Debt Ratio = Total Debt / Total Assets

• Interest coverage ratio: This ratio provides an insight into the business’s ability to pay interest amount accrued on its debt.

Interest Coverage Ratio = Earnings Before Interest and Tax / Interest Expense

1. Performance ratios

As the name suggests, the performance ratios indicate the company’s performance in the market, its profit and loss. They are also referred to as the profit and loss ratios. These include:

• Net profit margin: This ratio directly tells the profit margin of a company and indicates how well it is run.

Net Profit Margin = Net Profit / Revenue

• Return on equity: As the name suggests, the ratio gives an insight into the returns on equity or the return on net assets.

Return on Equity = Net Income / Shareholders’ Equity

• Operating profit margin: It refers to the profit margin earned by a business before the deduction of taxes and interests.

Operating Profit Margin = Operating Profit / Revenue

• Return on assets: How well a company generates returns on its assets is determined by the return on asset ratio.

Return on Assets = Net Income / Total Assets

• Gross profit margin: The relation between gross sales and profits is presented by this ratio.

Gross Profit Margin = (Revenue – Cost of Goods Sold) / Revenue

1. Liquidity ratios

The liquidity ratios of a company determine the suitability of a company to pay its debts. It tells whether there is enough liquidity to pay debts and also finance the running operations or not. Mostly new and small first deal with the issue of liquidity from time to time. The most common liquidity ratios are:

• Current ratio: It tells the success of a company in settling its expenses over the next 12 months.

Current Ratio = Current Assets / Current Liabilities

• Operating cash flow margin: It reflects the efficiency of a company to generate cash flow from sales.

Operating Cash Flow Margin = Cash from operating activities / Sales Revenue

• Quick ratio: It compares the cash, marketable securities and receivables against the liabilities to know the possibility of meeting the obligations.

Quick Ratio = (The Current Assets – Inventory)/Current Liabilities

• Cash ratio: It showcases the total cash of a company in comparison with its assets.

Cash Ratio = (Cash + Cash Equivalents) / Total Liabilities

1. Valuation ratios

The valuation looks at the valuation of the company, and its stock price to determine whether it is a good investment opportunity or not. These ratios are also known as market ratios. The common valuation ratios are:

• Price to sales ratio: This ratio compares the company’s total market capitalization with the previous year’s sales to measure the value of investment.

Price to Sales Ratio (P/S) = Market Capitalization/Total Revenue

• Price-to-earnings ratio: This ratio gives insight into whether a firm is overvalued or undervalued based on the previous earnings

Price to Earnings Ratio (P/E) = Price per share / Earnings per share

• PEG ratio: This ratio measures the stock’s underlying value by calculating the trade-off between stock price, earnings per share and predicted growth.

PEG Ratio = Price to Earnings / Growth Rate

• Cash flow: It gives a comparison of the company’s stock price and the cash it generates.

Price/Cash Flow (P/CF) = Share Price / Operating Cash Flow per Share

1. Activity ratios

The activity ratios are a measure of the effectiveness of a company’s operations and how well they use their resources. Some commonly used activity ratios are:

• Asset turnover: The effectiveness of a company in producing sales using its assets is measured by this ratio.

Total asset turnover = Net Sales / Average Total Assets

• Inventory turnover: The effectiveness of the management of inventory is reflected by this ratio.

Inventory turnover = Net Sales / Average Inventory at Selling Price

• Fixed asset turnover: This ratio determines the efficiency of a company to generate sales from its fixed assets.

Fixed asset turnover = Net Sales / Average Fixed Assets

• Receivables turnover: The speed at which the net sales are converted into cash is determined by this ratio.

Receivables turnover = Net Sales / Average accounts receivable

• Payables turnover: It gives insights into the number of times a company pays off its accounts payables in a given period.

Payables turnover = Total supply purchase / Average Accounts Payable

Conclusion

Incorporating a combination of these ratios in your financial analysis, you can carefully assess the financial position of a company. These ratios provide insight into different aspects of a company and help analyse it from different perspectives. To learn more, read StockGro blogs.

FAQs

What are the uses of ratio analysis

The ratio analysis helps in assessing the financial position of the company by measuring its overall performance.

What are the objectives of ratio analysis?

The objective of ratio analysis is to provide insight into a company’s functioning from different lenses that help assess its profitability.

Ratio analysis helps provide insight into the financial position of a company. However, the ratios must be calculated from time to time as they change frequently.

What is the classification of ratio analysis?

Ratio analysis can be classified into leverage, performance, liquidity, etc.

Are there any limitations of ratio analysis?

The ratio analysis sometimes only provides a limited outlook for evaluating a business’s performance.