Financial Ratio Analysis

Financial ratio analysis compares financial data to assess performance over time and across companies.
Financial Ratio Analysis
3 min
02-July-2024

Financial ratios provide a way for investors, businesses, and analysts to gauge the financial health and performance of a company.

Financial ratio analysis is a crucial tool for understanding a company's financial health and operational efficiency. This article delves into the essentials of financial ratio analysis, exploring its definition and significance in evaluating business performance. We will examine various types of financial ratios, such as liquidity, profitability, leverage, and efficiency ratios, and discuss how each provides unique insights into different aspects of a company's financial status. Additionally, we will guide you through the practical application of these ratios, demonstrating how to interpret and use them to make informed financial decisions and strategic planning. Join us as we uncover the comprehensive framework and benefits of financial ratio analysis.

What is financial ratio analysis?

Financial ratio analysis is a quantitative method that analyses the relationship or ratio between two or more financial outcomes. Doing so provides insights into the operational efficiency and profitability of a business. To conduct financial ratio analysis, data from documents such as the balance sheet, P&L statements, and expense accounts is computed and compared.

With the help of financial ratios, you can gain a deeper understanding of a company's performance in a given time frame. This data can also be used to compare with industry averages to see how your business fares to others in the sector.

Also read: What are personal funds?

What are the types of financial ratio analysis?

There are different types of financial ratios, each of which reflects different aspects of a company’s financial operations. However, these numbers are time-sensitive, and the data used to calculate them also changes over time.

Financial ratio analysis is especially important for investors as it helps them make informed decisions about the risks and rewards of investing in a company.

1. Liquidity ratio

The liquidity ratio measures whether a company can meet its short-term capital needs or debt obligations from its current assets without relying on external capital.

Two widely used liquidity ratios are:

  • The current ratio, also known as the working capital ratio, is the ability of a company to cover its short-term liabilities with its short-term assets.
  • The quick ratio, also called the acid test ratio, indicates a company's capacity to meet its debts in the short term using its most liquid assets.

2. Solvency ratio

The solvency ratio analyses a company's ability to pay off all its debt using its assets, such as income, dividends, and other tangible assets. This ratio highlights a company's long-term financial stability by examining its debt levels relative to its assets or equity.

Two widely used liquidity ratios are:

  • Total debt ratios measure the proportion of a company's assets that are financed by liabilities, indicating overall debt leverage.
  • The debt-to-equity ratio evaluates the financial leverage of a company. It compares its total liabilities to its shareholders' equity, showing how much debt is used to finance assets relative to equity.

3. Efficiency ratio

These ratios are also called activity ratios, as they evaluate how efficiently the assets and liabilities of the business are being used to maximise profit and generate more sales.

The most commonly used efficiency ratios are inventory turnover ratio, days sales outstanding, receivable turnover, fixed assets turnover ratio, and total assets turnover ratio.

4. Coverage ratio

The coverage ratio measures whether a company can fulfil its financial obligations and service its debt. Simply put, this ratio compares the cash flow or income to outflow or expense in the form of debt, lease, loan repayments, etc.

Two widely used coverage ratios are:

  • The interest coverage ratio assesses how easily a company can pay interest on outstanding debt with earnings before interest and taxes (EBIT).
  • The debt service coverage ratio evaluates the firm’s ability to cover all debt service payments with its net operating income.

5. Market value ratio

This ratio reflects the perception of the company in the market at large. Market value ratios, such as the price-to-earnings ratio and the price-to-book ratio, reflect the future growth and profitability of the company. Based on these ratios, investors decide whether the stock of a certain business is overvalued or undervalued.

6. Profitability ratio

This ratio analyses the ability of a business to generate earnings from its assets, equity, and sales. It helps evaluate the financial viability and performance efficiency of a company.

The most frequently used profitability ratios comprise the gross profit margin, operating margin, and return on assets.

Also read: What is ratio analysis?

How to use financial ratio analysis?

Now that you are aware of the different types of financial ratios, let us look at how to use financial ratio analysis:

  1. Financial ratio analysis can be used to get a better understanding of the progression of the business operations of a company over time.
  2. Using financial ratio analysis, you can draw comparisons between different companies and competitors to get a fair idea of a given company’s performance.
  3. Ratio analysis can be used to compare a company's financial performance against specific targets or standards. These targets can be set by the company based on industry standards. The goal is to see how well the company is doing and to make improvements if needed.

Example of financial ratio analysis

Let us now understand financial ratio analysis with an example:

The current ratio is a simple liquidity ratio that helps us analyse if a business can cover its short-term liabilities with short-term assets. Consider a company whose short-term assets are worth Rs. 2,50,000 and its short-term liabilities Rs. 1,150,00.

Current ratio = Current assets / Current liabilities

Current ratio = 2,50,000/1,50,000 = 1.67

When the current ratio of a business is 1, it indicates that the company has the exact required amount to pay off its current liabilities with current assets.

A ratio less than 1 means the company cannot meet its obligations. A ratio of 1.67, in the above example, shows that the business can pay its current liabilities.

Also read: How the treynor ratio works

What are the objectives of performing a financial ratio analysis?

Here are a few reasons why companies and investors prefer to perform a financial ratio analysis:

  • Financial ratio analysis helps simplify complex accounting information.
  • These ratios help determine the short-term liquidity and long-term liquidity of a business.
  • Financial ratio analysis can be used to assess the operational efficiency of an organisation.
  • These ratios play a crucial role in analysing the profitability of a business.
  • Financial ratio analysis allows for comparative analysis between businesses operating in the same domain or between competitors.

What are the advantages of financial ratio analysis?

The benefits of financial ratio analysis are provided below:

  1. It enables comparative analysis across companies and industries, regardless of size.
  2. Financial ratio analysis helps with trend identifications over time, aiding in strategic planning.
  3. It supports informed decision-making in finance, investments, and operations.
  4. Performance evaluation becomes easy with these ratios since a clear picture of management's performance in utilising resources is presented.

What are the disadvantages of financial ratio analysis?

Financial ratio analysis also comes with specific drawbacks:

  1. It relies on historical data, which may not predict future conditions.
  2. Not all companies follow one standardised practice. Hence, variations in accounting policies can lead to discrepancies.
  3. Ratios provide a snapshot view at a specific time point, missing the bigger picture.
  4. It may lead to overgeneralization, which can result in misleading conclusions if not used judiciously.

Financial ratio analysis example

Let us take a conglomerate, ABC Limited, as a financial ratio analysis example.

A thorough analysis of their balance sheet, P&L statement, and other financial documents might show a debt-to-equity ratio of 0.5. This means the company has a balanced approach to debt and equity in their capital structure.

Now, let us look at the company's Return on Equity (ROE), which is around 15%. This indicates the efficient use of equity capital to generate profits.

If the current ratio is above 1, for instance, 1.5, it means good short-term financial health. ABC Limited is capable of covering its current liabilities with its current assets.

This type of financial ratio analysis gives investors and analysts a clear snapshot of the company's financial standing in a competitive market.

Also read: What are liquid mutual funds?

Conclusion

Financial ratio analysis is essential for a vibrant economic landscape. India has thousands of large companies in different industries, each with unique financial footprints. Ratio analysis helps in understanding their financial stability and identifying growth opportunities.

As an investor, if you do not want to invest in the shares of just one company and want a more diversified portfolio to reduce individual stock risks, mutual funds are a great option. With mutual funds, you get exposure to a range of assets and sectors, optimising investment returns depending on your financial goals and risk appetite.

If you want to start investing in mutual funds, the Bajaj Finserv Mutual Fund Platform can be incredibly helpful. The platform lets you examine over 1,000 mutual fund schemes and compare mutual funds to find the one that aligns with your investment goals and risk tolerance. After that, you can either make lump sum investments or start an SIP investment to build your portfolio and achieve your financial goals.

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Frequently asked questions

What is financial ratio analysis?
Financial ratio analysis is a method used to evaluate the financial health and performance of a company by calculating key ratios from financial statements. These ratios provide insights into a company's profitability, liquidity, efficiency, and solvency.
What are the uses of financial ratio analysis?
Financial ratio analysis is used to assess a company's financial stability, compare its performance with industry benchmarks, and guide investment and operational decisions.
What is ratio in financial analysis?
In financial analysis, a ratio is a quantitative relationship between two numerical values from a company's financial statements, used to evaluate various aspects of its financial health and performance.
What are the main financial ratios analysis?
The main financial ratios in analysis include liquidity ratios (like Current and Quick Ratios), solvency ratios (like Debt-to-Equity and Interest Coverage Ratios), profitability ratios (such as Return on Assets and Gross Margin), and efficiency ratios (like Inventory Turnover and Asset Turnover Ratios).
How do you make a financial ratio analysis?
To perform a financial ratio analysis, gather financial statements, calculate relevant ratios (such as liquidity, solvency, profitability, and efficiency ratios), and compare these ratios to industry benchmarks or historical data to assess performance and financial health.
Why are financial ratios important?
Financial ratios are important because they provide quick insights into a company's financial health, operational efficiency, and overall performance, helping stakeholders make informed decisions.
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Disclaimer

Bajaj Finance Limited (“BFL”) is an NBFC offering loans, deposits and third-party wealth management products.

The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

This information should not be relied upon as the sole basis for any investment decisions. Hence, User is advised to independently exercise diligence by verifying complete information, including by consulting independent financial experts, if any, and the investor shall be the sole owner of the decision taken, if any, about suitability of the same.