Ratio analysis is the most important and crucial tool in the world of accounting and finance since it allows investors to justify the financial performance of a company. So, it is possible to gain valuable insights into a company’s trends, liquidity, solvency, profitability, and efficiency. In fact, for most users in the business world, these terms are relatively well known. Due to diversity and a lack of practice, sometimes financial ratio analysis calculations become complicated.

Key Financial Ratio:

Financial ratio analysis discover the company’s financial well-being and performance. Financial ratios are generally categorized as: 1. Liquidity ratio, 2. Solvency ratio, 3. Profitability ratio and 4. Efficiency ratio.

1. Liquidity ratio:

The liquidity ratio measures the company’s short-term financial health as well as ensures the smooth operation of day-to-day activities. Liquidity ratios are measured by the following ratios:

1.1 Current Ratio:

The current ratio is calculated by using current assets and current liabilities. Current assets and current liabilities are the elements that show the company’s position for the next financial year (the next twelve months). It shows how a company can pay short term obligations by using its assets. Generally, the industry standard for the current ratio is 2:1.

Example:

As per the financial statement of Company X, current assets are $900,000 and current liabilities are $500,000.

Current Ratio = Current Assets / Current Liabilities

Thus, Current Ratio = $900,000 / $500,000

Current Ratio = 1.8

Company X has $1.80 in current assets for every $1.00 in current liabilities. This is considered a good level of liquidity, so the company can pay-off debts from its assets if unexpected cash flow problem arises.

1.2 Quick Ratio or Acid Test Ratio:

Quick ratio is calculated by using current assets except inventories and current liabilities. It shows how a company can pay short term obligations by using more liquid assets. Generally, industry standard for current ratio is 1:1.

Example:

As per the financial statement of Company Y, current assets are $900,000, inventories are $300,000 and current liabilities are $500,000.

Quick ratio = (Current Assets – Inventories) / Current Liabilities

Thus, Quick ratio = ($900,000 – $300,000) / $500,000

Quick ratio = 1.2

Company Y has $1.20 in current assets for every $1.00 in current liabilities. This is considered a good level of liquidity, and the company can pay-off debts more quickly from its assets if an unexpected cash flow problem arises.

2. Solvency / Leverage Ratio:

The solvency ratio measures the company’s long-term financial health and ability to pay long-term obligations. This ratio measures how the company utilized the borrowed money.

2.1 Debt-to-Equity Ratio:

The Debt-to-Equity Ratio (D/E Ratio) calculated by comparing the company’s total debt and total shareholder equity. This ratio measures how much debt the company uses to finance its operations and how it utilizes the borrowed money. A higher D/E ratio means the company may have difficulty paying its debt if profit is declines. Generally, D/E ratio above 1 and below 2 is considered good.

Example:

As per the financial statement of Company Z, Total debt is $1,300,000 and shareholders’ equity is $1,100,000.

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

Thus, Debt-to-Equity ratio = $1,300,000 / $1,100,000

Debt-to-Equity ratio = 1.18

Company Z has $1.18 in debt for every $1.00 in shareholders’ equity.

2.2 Debt Ratio:

The debt ratio is calculated by comparing the company’s total debt and total assets. This ratio measures how much of a company’s assets are financed by debt. A higher debt ratio means the company has more debts to pay, which is not always good for the company. Generally, a debt ratio less than 0.5 is considered as good.

Example:

As per the financial statement of Company A, total debt is $2,100,000 and total assets is $4,500,000.

Debt ratio = Total Debt / Total Assets

Thus, Debt ratio = $2,100,000 / $4,500,000

Debt ratio = 0.47

Company A’s has debt ratio is 0.47, which means that 47% of its assets are financed by debt.

3. Profitability Ratio:

The profitability ratio measures the company’s ability to generate profits from revenue, assets, and equity. Higher profitability is considered better for the company.

3.1 Gross Profit Margin:

Gross profit margin is calculated by comparing the company’s revenue and cost of goods sold (COGS). This ratio measures how much a company’s cost of goods sold is in percentage of revenue. A higher gross profit margin is good for the company.

Example:

As per the financial statement of Company B, revenue is $1,800,000 and COGS is $1,200,000.

Gross Profit Margin = (Revenue – COGS) / Revenue

Thus, Gross Profit Margin = ($1,800,000 – $1,200,000) / $1,800,000

Gross Profit Margin = 0.33

Company B has a gross profit margin of 0.33, which means that the company retains 33% of its profit after payment for the cost of goods sold.

3.2 Net Profit Margin:

Net profit margin is calculated by comparing the company’s net profit and revenue. This ratio measures the company’s net profit percentage relative to revenue. A higher net profit margin is good for the company.

Example:

As per the financial statement of Company C, revenue is $2,000,000 and net profit is $500,000.

Net Profit Margin = Net Profit / Revenue

Thus, Net Profit Margin = $500,000 / $2,000,000

Net Profit Margin = 0.25

Company C has a gross profit margin of 0.25, which means that it retains 25% of its revenue as profit after all expenses.

3.3 Return on Equity:

Return on Equity (ROE) is calculated by comparing the company’s net profit and shareholders’ equity. Generally, this ratio measures how much the company’s net profit percentage is relative to shareholders’ equity. A higher net profit margin is good for the company.

Example:

As per the financial statement of Company D, shareholders’ equity is $2,800,000 and net profit is $300,000.

Return on Equity = Net Profit / Shareholders’ Equity

So, Return on Equity = $300,000 / $2,800,000

Return on Equity = 0.11

Company D has a return on equity of 0.11, which means that the company has generated an 11% return on equity invested by shareholders.

4. Efficiency Ratio:

The efficiency ratio measures the company’s ability to generate sales and profits by using the resources available. It measures the company’s operational efficiency and resource utilization.

4.1 Inventory Turnover:

To calculate inventory turnover, the company compares its cost of goods sold with its average inventory. So, this ratio measures how efficiently the company managed its inventory by selling and replacing it over a period of time. Higher inventory turnover is good for the company.

Example:

As per the financial statement of Company XY, cost of goods sold is $2,000,000 and average inventory is $400,000.

Inventory Turnover = Cost of Goods Sold / Average Inventory

Thus, Inventory Turnover = $2,000,000 / $400,000

Inventory Turnover = 5

Company XY has an inventory turnover of 5, which means that it has sold and replaced inventory five times in a year.

4.2 Receivables Turnover:

The company calculates receivables turnover by comparing its credit sales and average accounts receivable. This ratio measures how quickly and efficiently the company collects receivables. A higher receivable turnover is good for the company.

Example:

As per the financial statement of Company ABC, credit sales are $1,500,000 and average receivables are $500,000.

Receivables Turnover = Credit Sales / Average Receivables

So, Receivables Turnover = $1,500,000 / $500,000

Receivables Turnover = 3

Company ABC has a receivables turnover of 3, which means that the company has collected outstanding accounts receivable three times in a year.

Limitations of ratio analysis:

Ratio analysis has several limitations:

• It relies on historical data and does not consider current or future conditions.
• Ratios can vary across different industries; for example, ratios for an airline company may not be comparable with those of retailers.
• Companies have varying accounting policies, making comparisons with other companies sometimes unsuitable.
• Manipulation of financial statements can lead to inaccurate ratio results.
• Making decisions solely based on ratio analysis without considering other factors may lead to inaccuracies.

In conclusion, financial ratio analysis provide various aspects of indicators that assess the company’s financial health and performance. Although ratios discover valuable insights, these are the one way to evaluate a company’s true performance.
For a comprehensive analysis and well-informed investment decisions, investors need to consider additional factors. These include the company’s industry, business characteristics, as well as its long-term objectives. Additionally, we will publish another article to explore how ratios correlate with the financial statements of a real company.

Curious about International Accounting Standards (IAS), Read this article: What is International Accounting Standards (IAS)?

This blog post is written by Monir Bhuiyan, a member of ACCA (Association of Chartered Certified Accountants) and ICAB (Institute of Chartered Accountants of Bangladesh).