In finance and accounting terms, ratio analysis is referred to as the extraction of financial data from a company’s financial statements and its quantitative/mathematical comparison. Financial analysis, then, generate certain results, which are used to check the financial health of the company, analyse the past as well as current financial performance and predict financial efficiency in future as well. Elements located in the financial statements effect the efficiency, effectiveness and profitability of the company and hence the decision-making process; to be done by the investors, stakeholders and company’s management. In ratio analysis, one or more than one company’s financial data is compared to analyse trends in market’s financial environment.
Ratio analysis is divided into following main categories, which are, liquidity, probability, solvency/financial leverage, efficiency/activity, coverage and market prospect ratios.
Liquidity ratios refer to the ability of a company to turn its assets into cash, quickly, to cover the current liabilities. Liquidity ratios are; acid-test/quick ratio, current ratio, cash ratio and working capital ratio.
Profitability ratios refer to the company’s ability to generate profits through operations of the company. Its common types are; return on assets, return on equity, return on investment, gross profit margin, operating profit margin and operating expenses ratio.
Solvency/financial leverage ratios compare debt with company’s assets (i.e. earnings) and determine the long-term possibility of the company to stay in the financial market. Company checks out, whether it will be able to pay its long-term cost of capital in the future. Debt to equity ratio and debt to asset ratio are its examples.
Activity/efficiency ratios are also called turnover/asset management ratios. Activity ratios consider how the company makes sales utilizing its liabilities and assets for profit maximization. Examples include; total asset turnover, fixed asset turnover, inventory turnover, investment turnover, receivables turnover, payable turnover and average collection period/day sales outstanding.
Coverage ratios are associated with the coverage of debt and other obligations in the form of interest payments, dividends, etc. Examples of coverage ratios include; debt-service coverage ratio, interest coverage ratio, dividend coverage ratio, assets coverage ratio and total cash flow coverage ratio.
Market prospect ratios are used by the investors in order to check the level of return on their investment and to analyse the market trends. Examples of this type of ratios are dividend pay-out ratio, dividend yield, price earnings ratio, earnings per share, etc.
(Sub types of these ratios are lengthy to be described here).
In short, ratio analysis helps in analyzing the financial position of a company quickly and easily, and make judgement in a simple manner, rather than finding minor details in the financial statements. One limitation of ratio analysis is that it focuses on the past information, but investors/marketers require present or future information. So analysts/investors make assumptions in order to predict the future financial forecast, but these assumptions may not always be correct.