Financial Ratio Analysis: Understanding Types, Applications, and Limitations

Financial ratio analysis is a practical method that governs the evaluation of an organization’s financial health by various businesses and their investors. The activities aim to analyse financial ratios obtained from financial statements, enabling stakeholders to make better decisions on profitability, liquidity solvency and efficiency of the company. This analysis defines how well a company performs compared to its competitors and the industry.

What is Financial Ratio Analysis?

This analysis can be conveniently and effectively performed using the financial ratio analysis as this forms part of the conventional analysis of companies’ financial statements. Applying ratios helps stakeholders and other users such as investors, creditors and the like in comparing the relative performance of the operation returns and liquidity positions as well as the solvency status of the enterprise. This article covers how the general concept of financial ratio analysis is carried out, the importance of ratio analysis, and how ratios are classified.

Also Read: Objectives of Financial Statement Analysis

Investors and analysts widely use ratio analysis because it takes time to scrutinize the financial statements of enterprises and enable them to invest in such enterprises. For example, the simple current stock price, when divided by earnings per share, gives the ratio known as the price-earning ratio or P/E ratio, which helps determine the value of the shares of a company.

The ratios determine the financial metrics of a company.

• It evaluates a company’s performance over time.
• It evaluates future performance.
• Analyzing where a particular company stands concerning the rest of the companies in its industry

Limitations of Ratio Analysis

Ratio analysis allows investors to study a company’s current state and prospects for further development. However, they can tweak small criteria to make their stock and company ratios appear better without altering the company’s fundamentals. To overcome this limitation, however, investors also require information on the variables behind ratios, what the ratios do and do not say, and how the latter are manipulative.

Ratios are also not applicable individually. However, they are very relative and should only be used with other ratios or financial indexes to provide a large perspective on the company and its performance compared to other companies in the same industry.

Also Read: Key Limitations of Ratio Analysis

Types of Ratios for Financial Ratio Analysis

It is possible to distinguish six types of available financial ratios depending on the data type they contain. Using ratios in each category will be useful to fully understand the company’s operations across multiple fronts, as it will reveal likely problem areas.

• Liquidity Ratios: Liquidity ratios are equations that divide the most easily and quickly negotiable current asset by current liabilities. These ratios are very relevant as they assist in answering whether a business organization can extend its pay for near-term abilities such as accounts payable, odd little loans and bills, among others, which may lead to financial troubles.

Liquidity Ratios Include:

• Current Ratio: The current ratios measure a company’s ability to pay off short-term liabilities with current assets.

Current Ratio =  Current assets/ current liabilities

• Quick Ratio (Acid-Test Ratio):

Quick Ratio = Current  Assets – Inventory   / Current Liabilities

• Cash Ratio:

Cash Ratio =   Cash + Cash Equivalents / Current Liabilities

• Solvency Ratios: These are also known as financial leverage ratios, which express company debt regarding its assets, equity, or earnings. Solvency ratios, derived by comparing amounts of debts to amounts of assets, equity or earnings, provide certain valuable measures. These are used to evaluate the cloner’s efficiency of an ongoing operation by a given firm every year for interest on borrowings and the balance.

   Solvency Ratios Includes

• Debt-equity ratios :

Debt-to-Equity Ratio =  Total Debt / Shareholders’ Equity

• Debt Ratio:

Debt Ratio = Total Debt/ Total Assets

• Interest coverage ratios :

Interest Coverage Ratio = Earnings Before Interest and Taxes ( EBIT) / Interest Expense

• Profitability Ratios: These ratios define an organization’s ability to profit from its operations. They compare the extent to which the firm can transcribe its income into a profit based on sales, cost, and expenses. The analysis of profitability ratios is very important when assessing a given firm’s financial performance and future outlook.
• Profit margin auto
• Return on assets
• Return on equity
• Return on capital employed
• Gross margin ratio

• Efficiency Ratios: These ratios reveal how effectively the companies have used the existing and purchased assets and resources in the form of sales or profits. These provide data on business productivity concerns, including stock sales ratio and ageing of accounts receivables.

• Inventory Turnover Ratio:

Inventory turnover ratio = Cost of Goods Sold (COGS) / Average Inventory

• Asset Turnover Ratio:

Asset Turnover Ratio =  Net Sales / Total Assets

• Receivables Turnover Ratio:

Receivables Turnover Ratio = Net Credit Sales / Average Accounts  Receivable

• Coverage Ratios: Coverage ratios assess the capacity of a business regarding its interests and cash, otherwise known as debt obligations. It also depicts the extent to which the firm earns enough money to meet all its interest costs and other fixed charges on a firm’s corporate financial structure. They analysed the effect of coverage ratios that demonstrate a direct relationship between the coverage ratios and credit risks within the company and risks to the creditors and investors.

• Interest Coverage Ratio:

Interest Coverage Ratio = Earnings Before Interest and Taxes (EBIT) / Interest Expense

• Fixed Charge Coverage Ratio:

Fixed Charge Coverage Ratio  = Earnings Before Fixed Charges and Taxes / Fixed Charges

• Debt-service coverage ratio (DSCR):

DSCR  = Net Operating Income / Total Debt Service

• Market Prospect Ratios: It further presents the future market outlook of the business as well as its worth according to an investor’s perspective on performance ratios. These ratios help the user calculate the budgeted rate of returns on the investment, the value of the stocks under consideration, and the competitiveness of the business in the contemporary business environment. It helps investors control their shares and the control to acquire the shares to retain them or sell the shares in light of company performance and growth ratio. Typically, a high figure in both these two ratios is a market reaction signal for positive expectancy. In comparison, any hint of lower value or the two ratios shows an undeveloped firm or issues with growth apprehensions.

• Earnings Per Share(EPS):

               EPS = Net Income – Preferred Dividends / Average Outstanding Shares

• Price to Earnings (P/E) Ratio:

P/E Ratio = Market Price Per Share/ Earnings Per Share (EPS)

• Dividend Yield: Dividend Yield = (Dividend Per Share / Market Price Per Share) * 100

• Price-to-Book (P/B) Ratio: P/B Ratio = Market Price Per Share / Book Value Per Share

Also Read: Accounting Ratio Analysis

Applications of Financial Ratio Analysis

Financial ratio analysis is one of the most important techniques that stakeholders employ to evaluate the financial novelties, technical performance and market reputation of any organization. It is used across decision-making, investment, and strategic plans.

• Evaluating Financial Health: It makes it possible to determine the general situation of the financing of an organization using the financial ratios. For instance, the liquidity ratio ascertains that the company can fulfil short-term commitments; in the same way, leverage executes solvency on a longer-term basis.

• Investment Decision-Making: Financial ratios help investors decide if a particular company is suitable for investment with the help of profitability, market prospect, and efficiency ratios. Rates such as Price Earnings (P/E) ratio and dividend yield are exceedingly useful in analyses of possible returns.

• Creditworthiness Assessment: Lenders and banks use coverage ratios and debt-to-equity ratios to evaluate the capacity of the company to service the loans and interest charges.

• Performance Benchmarking: Companies take an interest in ratios as they provide a means of comparing Existing standards in similar organizations or themselves and setting goals for alteration.

• Detecting Financial Risks: The solvency and liquidity ratios will help the stakeholders create alerts about potential financial problems or bankruptcy.

Conclusion

A financial ratio analysis is another efficient technique to assess a company’s financial position. By combining different ratios and their analysis, potential investors, creditors, and management can make correct decisions on more investments, loans, or changes to existing strategies.

However, before proceeding with this analysis, it is crucial to remember the general and the restrictions to get the correct and valuable results. Enhance your financial expertise and career growth with the Hero Vired Certificate Program in Financial Analysis, Valuation, and Risk Management offered in collaboration with edX and Columbia University.