Ratio Analysis Definition And Example
Ratio analysis provides quantitative insight of a business’s liquidity. It can also see profitability and operational efficiency. It is done by looking at the company’s financial statements. These include the income statement and balance sheet. Fundamental equity analysis is built around ratio analysis. Let’s explore more about this revealing metric.
Table of Contents
- To calculate ratio analysis, you need to divide your net income by your revenues.
- Ratio analysis compares line data from your liquidity, profitability, and operational efficiency.
- Ratio analysis is essential for gauging your company’s performance over time.
What Is Ratio Analysis?
A ratio analysis is a way to examine the relationship between two numbers. For example, if you are looking at the revenue of a business and its profit margin, you can use ratios to determine what the profit per unit is.
For example, if the business sells 100 units and earns a profit of 10 dollars on each unit, its profit margin is 10/100 or 10%. In this case, its revenue would be 10 times its profit or 100 dollars.
What makes ratio analysis useful is that it allows you to find out how much of a specific business metric is attributable to each of its inputs.
For example, you can find out how much of a business’s revenue comes from its product sales versus its service revenue. If a business has a profit margin of 30%, then it means that for every 100 dollars of revenue generated, it made a profit of 30 dollars.
What Can You Learn from Ratio Analysis?
Analysts and investors use ratio analysis to assess financial health and financial condition. They look at past and present financial statements.
Comparative data is useful for comparing the performance of a company over time. It is useful to predict future performance. These data compare a company’s financial standing. But it’s against industry averages and measures how a company ranks with others in the same sector.
Investors can use ratio analysis. All figures needed for calculating the ratios are in a company’s financial statements.
Investors can easily use current ratio analysis. Every figure required to calculate the ratios are in a company’s financial statements. This tells whether there are current assets and current liabilities. You’ll need to acquire a statement of cash flows to better determine the company’s financial position.
Moreover, it’s important to seek out debt levels. You’ll be able to gauge financial performance this way. In addition, be sure to look for any obsolete inventory and days sales outstanding to gain a clearer picture of the company’s asset base.
It’s important to see how the company performed over a certain financial reporting period. You will also need to look back at previous periods to learn about annual earnings and overall performance.
Understanding a company’s common equity is equally important. And if they’re in debt, determine their asset coverage ratio. All of the company ratios are essential to investors.
Ratio Analysis Examples
Based on the data that they provide, the various cash ratio methods are possible to group into six silos:
1. Liquidity Ratio
An important liquidity ratio for any business is the current ratio. This is the amount of assets a business has divided by the amount it owes its liabilities. This ratio shows the available amount of cash a company has on hand, which may not be very liquid, meaning it may have to borrow to stay afloat. The current ratio is calculated by dividing a company’s current assets by its current liabilities.
Current assets expect to turn into cash within one year, while current liabilities are the business’s debt obligations. Both of these are due in a year’s time, so they’re not very liquid. A more liquid ratio is the quick ratio.
This is the current assets plus the company’s cash on hand divided by its current liabilities. The liquidity ratio compares a company’s liquidity to industry averages. The higher the ratio, the more liquid the company gets compared with its industry.
2. Solvency Ratios
The solvency ratio compares a company’s current assets to its current liabilities. This ratio indicates a company’s ability to meet its financial obligations. A high solvency ratio indicates that a company is generating enough income to cover its expenses.
A low solvency ratio may indicate that the company is not generating enough money to pay its bills. A company with a ratio of 1 may be able to pay its bills for the next year, but it won’t be able to cover any new expenses. For a company with a ratio of 2, the solvency ratio is better, but the company still has significant liabilities to cover.
3. Profitability Ratio
The profitability ratio compares net income to revenue. It indicates how much profit a company is making per dollar of revenue. The gross profit margin shows how much profit a company is making on each unit of sales.
The operating profit margin shows how much profit is made by operating the business. The overall profitability ratio shows the profitability of all sources of income. The net profit margin shows the percentage of revenue that is profit.
The gross profit margin and the operating profit margin are often confused. The gross profit margin is the percentage of revenue that’s left after costs. The operating profit margin is the percentage of revenue that’s left after both costs and taxes are cut out.
4. Efficiency Ratios
The working capital ratio is the current ratio of a company’s accounts receivable to its accounts payable. This shows how much cash a company has on hand from its sales, minus its accounts receivable.
The ratio indicates whether the company has too much or too little cash tied up. This is in relation to its customers, which may indicate its overall financial health.
A high ratio may be a red flag that the company may be experiencing financial difficulties. A ratio of 1 means that the company is cash-flow positive, while a ratio of 0 means it is cash-flow negative.
5. Coverage Ratios
The coverage ratio compares a company’s assets to its debts. It indicates how much equity a company has as a percentage of its liabilities. A high percentage indicates that the company has plenty of assets to cover its debts.
A low ratio may indicate that the company is too leveraged and needs to reduce its debts. The coverage ratio is often used in conjunction with the debt-to-equity ratio. Both ratios show how much debt a company has relative to how much equity it owns.
6. Market Prospect Ratio
The market share of products and services shows how popular a company’s products are compared to the rest of the market. The market value of a company shows how much the market values the company’s assets, such as its shares of equity.
The market capitalization of a company shows how much money it would take to buy the company’s shares. The market share of a company shows how many products and services it offers in the market, as well as how much of the market they occupy.
You should now be able to calculate operating profit margin and understand what makes a profitable company. The most profitable businesses in the world generate high profits while reducing their expenses.
Frequently Asked Questions about Ratio Analysis
Are there any issues with ratio analysis?
This metric can’t measure human elements within a firm.
How can you improve your current ratio?
Start with delaying your capital purchases. See if you can re-amortize any loans. And be sure to limit your personal draw within your company.
What are uses of ratio analysis?
This metric reveals insights into your profitability, solvency, liquidity, and operation efficiency.
What are the advantages of ratio analysis?
Ratio analysis is a beneficial metric to see how well a company performs over time. Moreover, it allows business owners to compare line data. From there, you make the necessary adjustments to your operations.
What are the limitations of ratio analysis?
Ratio analysis only takes qualitative aspects into account. As such, it doesn’t look at the reason behind amount fluctuations.
Why are ratios important in real life?
Ratios play a key role in putting life’s numbers into clearer focus.
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