Ratio analysis (also known as financial statement analysis) is an important financial tool used by investors and financial analysts to review the financial statement of a company. Ratios capture relationships between different elements of financial statements, like stocks, debts, assets, income, expenses, shares, etc., and provide insight into a company’s financial performance and position. With the help of ratio analysis, users can compare a company’s financial performance with that of its competitors, understand its position in the industry, and make important investment decisions.
Types of Users of Ratio Analysis
Ratio analysis is a valuable tool that can be used by various stakeholders to understand the financial performance and future prospects of companies. Different types of users of ratio analysis include the following:
-
Banks and Financial Institutions:
Banks and other financial institutions use ratio analysis to evaluate the credit-worthiness of a company and determine whether to grant a loan or an overdraft facility. Ratios like debt equity ratio, quick ratio, current ratio, fixed-assets to net worth ratio, and operating profit margin are used to gauge a company’s ability to repay its loans and other borrowings. -
Investors: Ratio analysis helps investors to determine the intrinsic value of a company and make informed investment decisions. Ratios like price-earnings (P/E) ratio, dividend yield, dividend payout ratio, and return on equity (ROE) enable investors to assess a company’s potential for growth.
-
Creditors: Creditors use ratio analysis to review a company’s ability to meet its future obligations. Ratios like debt-servicing capacity, debt coverage ratio, and times-interest-earned (TIE) ratio help them to assess the company’s safety when considering making an advance credit or loan to the company.
-
Government and Regulatory Agencies:
Government agencies and regulatory authorities use ratio analysis to assess the financial stability of companies. Ratios like solvency ratio, liquidity ratio, and debt servicing ratio help them to gauge the financial strength and make sure companies adhere to prudential regulations. -
Management: Business owners and company’s management use financial ratios for internal analysis (also known as management ratio analysis). Analysis of liquidity position, profitability, solvency, and inventory management help management to identify areas that need improvement and take corrective measures.
-
Employees: Ratio analysis is used by employees within an organization to compare their individual performance with that of their teams and the overall organization. This helps them to understand if their efforts are paying off in terms of business growth and competitiveness.
Common Ratios Used in Ratio Analysis
Ratio analysis uses multiple ratios to measure different aspects of a company’s financial performance. Here is a list of some of the commonly used ratios in ratio analysis:
-
Liquidity Ratios:
Liquidity ratios measure a company’s ability to meet its short-term debt obligations. Examples include current ratio, quick ratio, and absolute liquidity ratio. -
Solvency Ratios:
Solvency ratios measure a company’s ability to meet its long-term debt obligations. Examples include debt-to-equity ratio, and interest coverage ratio. -
Profitability Ratios:
Profitability ratios measure a company’s ability to create wealth for its shareholders. Examples include gross profit margin, operating profit margin, and return on equity (ROE). -
Activity Ratios:
Activity ratios measure the efficiency with which a company uses its resources. Examples include inventory turnover, accounts receivable turnover, and fixed assets turnover. -
Market Ratios:
Market ratios measure the performance of a company’s stock in the financial markets. Examples include price-earnings (P/E) ratio, price-book (PB) ratio, and dividend yield.
Ratio analysis is an important tool used by stakeholders to evaluate a company’s financial performance and to make important decisions. Financial ratios help investors, creditors, and banks to understand the financial stability of a company and make informed investments, loans, and other financial decisions. Ratio analysis also helps management of the company to analyze their financial performance in comparison to their competitors, and identify areas that need improvement.
