What is Ratio Analysis: Meaning, Types of Ratios & their Formulas. In the previous articles, we have given IRR (Internal Rate of Return) and CAGR (Compound Annual Growth Rate). Today we are discussing what is ratio analysis, objectives of ratio analysis, different types and their formulas. A ratio analysis is a quantitative analysis of information contained in a company’s financial statements. Ratio analysis is based on line items in Financial Statements like the Balance Sheet, Income Statement, and cash flow statement; the ratios of one item – or a combination of items – to another item or combination are then calculated. Ratio analysis is used to evaluate various aspects of a company’s operating and financial performance such as its efficiency, liquidity, profitability and solvency.
The trend of these ratios over time is studied to check whether they are improving or deteriorating. Ratios are also compared across different companies in the same sector to see how they stack up, and to get an idea of comparative valuations.
Short-term Solvency or Liquidity Ratios
|1||Current Ratio||Current Assets/Current Liabilities|
|2||Quick Ratio||Liquid Assets/Current Liabilities|
|3||Absolute Liquid Ratio||Absolute Liquid Assets/Current Liabilities|
The Current Ratio is calculated by dividing Current Assets by Current Liabilities. Current Assets are the assets that the firm expects to convert into cash in the coming year and Current Liabilities represent the liabilities which have to be paid in cash in the coming year. The appropriate value for this ratio depends on the characteristics of the firm’s industry and the composition of its Current Assets. However, at a minimum, the Current Ratio should be greater than one.
The Quick Ratio recognizes that, for many firms, Inventories can be rather illiquid. If these Inventories had to be sold off in a hurry to meet an obligation the firm might have difficulty in finding a buyer and the inventory items would likely have to be sold at a substantial discount from their fair market value.
This ratio attempts to measure the ability of the firm to meet its obligations relying solely on its more liquid Current Asset accounts such as Cash and Accounts Receivable. This ratio is calculated by dividing Current Assets less Inventories by Current Liabilities.
|1||Gross Profit Ratio||Gross Profit/Net Sales X 100|
|2||Operating Cost Ratio||Operating Cost/Net Sales X 100|
|3||Operating Profit ratio||Operating Profit/Net Sales X 100|
|4||Net Profit Ratio||Operating Profit/Net Sales X 100|
|5||Return on Investment Ratio||Net Profit After Interest And Taxes/ Shareholders Funds or Investments X 100|
|6||Return on Capital Employed Ratio||Net Profit after Taxes/ Gross Capital Employed X 100|
|7||Earnings Per Share Ratio||Net Profit After Tax & Preference Dividend /No of Equity Shares|
|8||Dividend Pay Out Ratio||Dividend Per Equity Share/Earning Per Equity Share X 100|
|9||Earning Per Equity Share||Net Profit after Tax & Preference Dividend / No. of Equity Share|
|10||Dividend Yield Ratio||Dividend Per Share/ Market Value Per Share X 100|
|11||Price Earnings Ratio||Market Price Per Share Equity Share/ Earning Per Share X 100|
|12||Net Profit to Net Worth Ratio||Net Profit after Taxes / Shareholders Net Worth X 100|
Market Value Ratios
1) Price-Earnings Ratio (P/E Ratio)
The Price-Earnings Ratio is calculated by dividing the current market price per share of the stock by earnings per share (EPS). (Earnings per share are calculated by dividing net income by the number of shares outstanding.)
The P/E Ratio indicates how much investors are willing to pay per dollar of current earnings. As such, high P/E Ratios are associated with growth stocks. (Investors who are willing to pay a high price for a dollar of current earnings obviously expect high earnings in the future.) In this manner, the P/E Ratio also indicates how expensive a particular stock is. This ratio is not meaningful, however, if the firm has very little or negative earnings.
2) Market-to-Book Ratio
The Market-to-Book Ratio relates the firm’s market value per share to its book value per share. Since a firm’s book value reflects historical cost accounting, this ratio indicates management’s success in creating value for its stockholders. This ratio is used by “value-based investors” to help to identify undervalued stocks.
The following are the ratios in structural group:
i) Funded debt to total capitalization:
The term ‘total’ capitalization comprises loan term debt, capital stock and reserves and surplus. The ratio of funded debt to total capitalization is computed by dividing funded debt by total capitalization. It can also be expressed as a percentage of the funded debt to total capitalization. Long term loans
Total capitalization (Share capital + Reserves and surplus + long term loans)
ii) Debt to equity:
Due care must be given to the; computation and interpretation of this ratio. The definition of debt takes two foremost. One includes the current liabilities while the other excludes them. Hence the ratio may be calculated under the following two methods:
Long term loans + short term credit + Total debt to equity = Current liabilities and provisions Equity share capital + reserves and surplus (or)
Long-term debt to equity = Long – term debt / Equity share capital + Reserves and surplus
iii) Net fixed assets to funded debt:
This ratio acts as a supplementary measure to determine security for the lenders. A ratio of 2:1 would mean that for every rupee of long-term indebtedness, there is a book value of two rupees of net fixed assets.
iv) Funded (long-term) debt to net working capital:
The ratio is calculated by dividing the long-term debt by the amount of the net working capital. It helps in examining creditors’ contribution to the liquid assets of the firm.
Ratio analysis can be used in the following ways:
- To know the financial strength and weakness of an organization.
- To measure the operative efficiency of a concern.
- For the management to review past year’s activity.
- To assess the level of efficiency.
- To predict the future plans of a business.
- To optimize capital structure.
- In inter and intra company comparisons.
- To measure liquidity, solvency, profitability and managerial efficiency of a concern.
- In the proper utilization of assets of a company.
- In budget preparation.
Advantages of Ratio Analysis
- It is a powerful tool to measure short and long-term solvency of a company.
- It is a tool to measure profitability and managerial efficiency of a company.
- It is an important tool to measure operating activities of a business.
- It helps in analyzing the capital structure of a company.
- Large quantitative data may be summarized using ratio analysis.
- It relates past accounting performances with the current.
- It is useful in coordinating the different functional types of machinery of a company.
- It helps the management in future decision-making.
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