Ratio analysis | Formulas, examples, limitations
When it comes to financial statement analysis, you can use ratio analysis formulas to interpret the data presented in financial statements (balance sheet, profit and loss) in a better manner. In this article, we start with the meaning and definition of ratio analysis, and then move on to examples of various financial ratios, before concluding with a summary of their limitations.
Introduction to Financial Statement Analysis
As we know, a ratio shows the relationship between two numbers. It shows how big one number is compared with another.
If we have three apples and two oranges, we say we have apples and oranges in the ratio of 3:2, or “three is to two.” This means that we have three apples for every two oranges.
In the world of finance, ratios indicate the performance of companies in key functions and help the managers and investors analyze the operations and sustainability of the businesses.
For example, the “current ratio,” or liquidity ratio, of a company gives the ratio of its current assets (assets expected to be encashed in 12 months) to its current liabilities (liabilities that need to be cleared in 12 months).
If we say that a company’s current ratio is 4:1, or 4, we mean that its current assets are four times its current liabilities—that is, the company can pay off its current debts four times over.
Uses of ratio analysis
Ratios calculated from the information in financial statements help investors in three ways:
- They simplify financial statements: Ratio analysis simply information given in companies’ financial statements. Investors can easily obtain data from a few ratios instead of trying to understand entire statements.
- They help detect a problematic trend: Each type of ratio analysed over a long period can point to a defect in the functioning of a business. The analysis can also predict the future performance of a company in a particular aspect of business.
- They facilitate comparisons: Ratios not only help analyse the performance of one company but also facilitate a comparison of the performances of two or more companies within an industry or a sector.
For example, two companies in the traditional manufacturing sector can be compared on the basis of their current ratios. A company with a current ratio of 3:1 can more easily clear its current debts than one with a current ratio of 1.5:1, for example.
These ratios can be compared with the general standard current ratio for companies in this sector, which may be 2:1.
Types of financial ratios
In the area of financial statement analysis, financial ratios are classified into the following broad categories: liquidity, solvency, efficiency, profitability, and valuation.
Liquidity ratios
Liquidity ratios show the cash availability of a company and its ability to meet short-term dues.
In other words, liquidity ratios are an indicator of a company’s capacity to clear its current liabilities (liabilities that need to be cleared in a year). They indicate not only the levels of cash but also assets that can be quickly converted into cash for meeting its obligations.
Examples of Liquidity ratios: Quick ratio (acid-test ratio) and working capital ratio (current ratio).
The quick ratio, or the acid-test ratio, measures the capacity of a company to clear its current liabilities using only its “quick assets” (assets that can be converted into cash within 90 days, including cash itself, besides short-term investments, marketable securities, etc).
Ratio Analysis Formula: The quick ratio is calculated by adding all the current assets and dividing this figure by current liabilities.
What does it mean to investors? The quick ratio shows how quickly a company can convert its quick assets into cash to clear its current dues, without disturbing its capital assets. This indicates the level of liquidity of the company.
Our second example, the working capital ratio, or the current ratio, shows whether a company can meet its current liabilities using its current assets (assets that can be converted into cash within a year: for example, cash and cash equivalents).
Ratio Analysis Formula for capital ratio: The working capital ratio is calculated by dividing current assets by current liabilities.
What does it mean to investors? This ratio indicates whether a firm has adequate cash to manage its daily operations, which is why it is known as the working capital ratio.
Solvency ratios
Solvency ratios indicate a company’s viability in the long term—whether it can meet its long-term obligations to creditors and sustain itself. These ratios compare the debt of a company with its equity, earnings, and assets.
Example of Solvency ratio: Debt-to-equity ratio.
The debt-to equity ratio relates the amount of debt taken on by a company to its equity. It shows how much of its funds have come from banks and other creditors compared with how much from its shareholders.
Formula for debt-to-equity ratio: The debt-to-equity is calculated by dividing the total liabilities by the total equity.
What does it mean to investors? The lower the debt-to-equity ratio, the better is the company’s health, since funding by shareholders and other investors is often seen as better than funding by banks and other creditors.
Efficiency ratios
Efficiency ratios show how efficiently a company uses its assets to make profits or convert its inventories into cash. These ratios measure how promptly a company is able to collect cash from its clients for goods or services delivered to them on credit.
In other words, the efficiency ratios indicate how efficiently the managers in charge of day-to-day operations are manufacturing and selling products to make profits.
Example of Efficiency ratio: Accounts receivable turnover ratio.
First, accounts receivable is the cash due to a company from its customers who enjoy credit. The accounts receivable turnover ratio expresses how efficient a company is at collecting cash owed to it by its clients for goods or services delivered on credit, or how many times (turns) a year it collects these amounts.
Ratio Analysis Formula: If a company’s average account receivable for a particular year is Rs. 1 crore (the average is calculated by using the receivables at the start and at the end of the year), and it collected Rs. 2 crore during the year, its accounts receivable turnover ratio is Rs. 2 crore divided by Rs. 1 crore, that is, 2.
This means that the company collected its accounts receivable twice during the year, or once every six months.
A company that has recorded an accounts receivable turnover ratio of 4 has collected its accounts receivable every 90 days, or four times a year.
What does it mean to investors? The higher the accounts receivable turnover ratio, the more frequently does the company collect its receivables, and, thereby, the more efficient it is.
Profitability ratios
Profitability ratios demonstrate how effectively a company is using its assets to gain profits.
Example of Profitability Ratio: Return-on-assets ratio.
The return-on-assets ratio relates the total net income of a company to the investment in its total assets during a period. It is an important index, since the ratio includes capital assets, often the largest investment for most businesses.
Ratio Analysis Formula: The return-on-assets ratio is calculated by dividing the net income by the average total assets (the total assets at the start and at the end of the year divided by two).
What does it mean to investors? A high return-on-assets ratio indicates that the assets are being used optimally; a low ratio shows that the investment in assets is higher than what is necessary or that the assets are not being utilised fully to earn profits.
Valuation ratios
Valuation ratios help investors measure the value of a company stock and decide whether to buy, hold, or sell its shares. These ratios also enable them to predict the future of the stock and what returns to expect from it.
Example of Valuation Ratio: Price earnings ratio.
The price earnings (PE) ratio is a valuation ratio that relates the price paid for a share to the earnings from it. It shows the stock market’s assessment of the value of a share of a company based on the share earnings declared.
Formula for Price earnings ratio: The ratio is arrived at by dividing the market value price for a share by earnings per share, and is usually calculated at the end of a financial year.
What does it mean to investors? The PE ratio gives the expected price of a share based on its earnings. It tells a share buyer what earnings can be expected from the share in the form of higher dividends or higher share price at the time of sale.
The ratio can be used to compare businesses in the same industry but is prone to manipulation by management. An extremely high ratio, for example, may indicate that profits have probably been overstated and that a fall in share price may be round the corner.
Therefore, as demonstrated above, financial ratios are signboards indicating the performance of a company on various parameters. Ratio analysis reveals to the investors the sustainability and future of their investments.
For example, certain figures may show that a company is profitable, but the relevant financial ratios may point to a problem in cash flows. Financial ratios, meanwhile, can notify managers about the areas in their companies that need their attention.
Limitations of Ratio Analysis
Although financial ratios and ratio analysis have many advantages, they have disadvantages, too:
- Historical or old data enter in the calculation of financial ratios and ratio analysis, making the information that they give far from being current.
- Various estimates go into calculating financial ratios, and therefore the information that ratio analysis purport to provide may not be accurate.
- Financial ratios and ratio analysis may not be an appropriate tool to compare companies from different sectors as they may be operating in extremely different economic environments.
They may not even be suitable to compare companies from the same sector as they may have differing corporate accounting practices and operational policies.
Important Finance Topics
– Introduction to Finance
— Balance Sheets
— Profit and Loss
— Cash Flow
— Discounted Cash Flow
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