Ratio analysis is a fundamental analysis tool to check the financial performance of a company. Learn its types and applications.
EXPLORE FUNDS
3 mins read
10-Apr-2024
Ratio analysis is a widely used fundamental analysis tool. It helps us see how well a company is doing financially. Whether you are just starting to invest, learning about finance, or running your own business, knowing about ratio analysis can help you make smart financial choices.
It lets you know where to put your money, how to manage your budget and plan for the future. Let’s understand the ratio analysis definition, its types, and practical application.
What is ratio analysis?
Ratio analysis is an examination and interpretation of various financial ratios to assess a company's:
- Profitability
- Liquidity
- Solvency, and
- Efficiency
These ratios are derived from a company's financial statements, which typically include the balance sheet, income statement, and cash flow statement. By comparing different ratios over time or against industry benchmarks, you can gain valuable insights into a company's financial performance.
How does ratio analysis help?
Ratio analysis serves several key purposes and helps investors in making better investment decisions. Let’s see them:
Performance evaluation
- Ratio analysis helps in evaluating the financial performance of a company over time.
- By examining trends in ratios you can assess whether a company’s financial health is:
- Improving
- Stagnating, or
- Declining
Comparison with industry benchmarks
- Ratio analysis allows for comparisons with industry benchmarks or standards.
- You can compare a company's ratios against:
- Industry averages or
- Competitors' performance
- This comparison helps you to:
- Identify areas of strength or weakness and
- Assess relative performance within the industry.
Identification of financial trends
- By examining ratios you can identify financial trends and patterns that can impact future performance.
- For example,
- A declining trend in profitability ratios signals inefficiencies or competitive pressures
- While an improving trend in liquidity ratios indicates a strengthened financial position
What are the types of ratio analysis?
Ratio analysis can be divided into four different types or categories. Let us see them:
Type I: Liquidity Ratios
Liquidity ratios help us see if a company can meet its short-term obligations on time. This type can be further divided into:
- Current ratio and
- Quick ratio
Aspects/Liquidity ratios | Current ratio | Quick ratio (or Acid-test ratio) |
Meaning | This ratio measures the company's ability to pay off its short-term liabilities with its short-term assets. | Unlike the current ratio, the quick ratio excludes inventory and prepaid expenses from current assets. This exclusion provides for a more conservative measure of liquidity. |
Formula | Current Assets / Current Liabilities | Quick Assets* / Current Liabilities Quick assets = Current Assets - Inventory - Prepaid expenses |
Ideal ratios |
|
|
Type II: Profitability Ratios
Profitability ratios help us understand how good a company is at making money relative to its revenue, assets, and liabilities. Let us understand these terms first:
Revenue
- This is how much money the company makes from selling its products or services.
- Profitability ratios show if the company is making enough profit compared to its revenue.
Assets
- These are things the company owns, like buildings, equipment, or cash.
- Profitability ratios help us see if the company is making good use of its assets to earn profits.
Equity
- This is the value of what's left for the company's owners after paying off all debts.
- Profitability ratios tell us if the company is earning enough profit for its owners compared to the money they've invested.
The profitability ratios can be further subdivided into three different types:
- Gross profit margin
- Net profit margin, and
- Return on equity (ROE)
Aspects/Profitability ratios | Gross profit margin | Net profit margin | Return on Equity (ROE) |
Meaning | This ratio measures the portion of revenue that remains after subtracting the cost of goods sold (COGS). | The net profit margin measures the percentage of revenue that remains after deducting all expenses, including taxes and interest. | ROE indicates how efficiently a company generates profits from its shareholders' equity. |
Formula | (Revenue - COGS) / Revenue × 100 | (Net Income / Revenue) × 100 | (Net Income / Shareholders' Equity) × 100 |
Type III: Solvency Ratios
Solvency ratios help us figure out if a company can handle its long-term financial obligations. Knowing this is crucial for several reasons:
A company with strong solvency ratios is seen as less risky and more attractive for investment, while companies with weak solvency ratios are viewed with caution.
Creditors, such as banks and bondholders, use solvency ratios to assess a company's ability to repay its debts. A company with favourable solvency ratios is more likely to receive:
Favourable loan terms and
Lower interest rates
By monitoring solvency ratios you can get early warning signs of potential financial distress.
Do you have trouble in making fundamental analysis of companies and picking stocks based on merit? Try investing in mutual funds. The Bajaj Finserv Platform has listed 1,000+ mutual fund schemes. You can compare them for free using mutual funds compare.
Solvency ratios can be further divided into two subtypes:
- Debt-to-equity ratio
- Interest coverage ratio
Aspects/Solvency ratios | Debt-to-equity ratio | Interest coverage ratio |
Meaning |
|
|
Formula | Total Debt / Shareholders' Equity | EBIT / Interest Expenses |
Ideal ratio |
|
|
Type IV: Efficiency Ratios
Efficiency ratios evaluate how effectively a company utilises its resources to generate revenue and manage its operations. We can further divide them into:
Inventory turnover ratio and
Accounts receivable turnover ratio
Aspects/Efficiency ratios | Inventory turnover ratio | Accounts receivable turnover ratio |
Meaning | This ratio measures how many times a company sells and replaces its inventory within a specific period. | This ratio assesses how efficiently a company collects payments from its customers. |
Formula | Cost of Goods Sold (COGS) / Average Inventory | Net Credit Sales / Average Accounts Receivable |
Example of Ratio analysis
ABC Enterprises is a manufacturing company engaged in the business of making LED lights. It has returned the following financial figures for the year ending March 31, 2024:
- Total Debt: Rs. 5,00,000
- Shareholders' Equity: Rs. 10,00,000
- Earnings Before Interest and Taxes (EBIT): Rs. 7,00,000
- Interest Expenses: Rs. 1,00,000
- Gross Profit: Rs. 15,00,000
- Net Profit: Rs. 8,00,000
- Revenue: Rs. 30,00,000
- Inventory at the Beginning of the Year: Rs. 2,00,000
- Inventory at the End of the Year: Rs. 1,50,000
- Accounts Receivable at the Beginning of the Year: Rs. 1,50,000
- Accounts Receivable at the End of the Year: Rs. 2,00,000
- Current Assets: Rs. 8,00,000
- Current Liabilities: Rs. 3,00,000
- Cash and Cash Equivalents: Rs. 2,50,000
- Purchases: Rs. 5,00,000
- Direct Expenses: Rs. 4,50,000
- Net Credit Sales = Rs. 20,00,000
Based on the above data, now, let's calculate the specified ratios:
Type of Ratio | Formula | Calculation | Ratio |
Debt-to-Equity Ratio | Total Debt / Shareholders' Equity | Rs. 5,00,000 / Rs. 10,00,000 | 0.5 |
Interest Coverage Ratio | EBIT / Interest Expenses | Rs. 7,00,000 / Rs. 1,00,000 | 7 |
Gross Profit Margin | (Gross Profit / Revenue) × 100 | (Rs. 15,00,000 / Rs. 30,00,000) × 100 | 50% |
Net Profit Margin | (Net Profit / Revenue) × 100 | (Rs. 8,00,000 / Rs. 30,00,000) × 100 | 26.67% |
Return on Equity (ROE) | (Net Profit / Shareholders' Equity) × 100 | (Rs. 8,00,000 / Rs. 10,00,000) × 100 | 80% |
Current Ratio | Current Assets / Current Liabilities | Rs. 8,00,000 / Rs. 3,00,000 | 2.67 |
Quick Ratio (Acid-test Ratio | (Current Assets - Inventory) / Current Liabilities | (Rs. 8,00,000 - Rs. 1,50,000) / Rs. 3,00,000 | 2.17 |
Inventory Turnover Ratio | Cost of Goods Sold (COGS) / Average Inventory | COGS = 2,00,000 + 5,00,000 + 4,50,000- 1,50,000 = 10,00,000 Average Inventory = (Rs. 2,00,000 + Rs. 1,50,000) / 2 = 1,75,000 Inventory turnover ratio = 10,00,000/ 1,75,000 = 5.71 | 5.71 |
Accounts Receivable Turnover Ratio | Net Credit Sales / Average Accounts Receivable | Average Accounts Receivable = (Rs. 1,50,000 + Rs. 2,00,000) / 2 = Rs. 1,75,000 Accounts Receivable Turnover Ratio = Rs. 20,00,000 / Rs. 1,75,000 = 11.43 | 11.43 |
What can we observe?
Based on the calculated ratios and financial figures for ABC Enterprises, we can make several common observations:
- Debt-to-Equity Ratio (0.5)
- ABC Enterprises has a relatively conservative capital structure, with a lower proportion of debt compared to equity.
- This indicates a lower financial risk and less reliance on borrowed funds for financing its operations.
- Interest Coverage Ratio (7)
- The interest coverage ratio of 7 indicates that ABC Enterprises is generating sufficient earnings to cover its interest expenses comfortably.
- This suggests a strong ability to meet its interest obligations and indicates financial stability.
- Gross Profit Margin (50%)
- ABC Enterprises has a healthy gross profit margin of 50%, indicating that it:
- Effectively manages its production costs and
- Generates a significant profit margin on its products.
- This suggests efficient cost management and pricing strategies.
- ABC Enterprises has a healthy gross profit margin of 50%, indicating that it:
- Net Profit Margin (26.67%)
- The net profit margin of 26.67% indicates that ABC Enterprises retains approximately 26.67% of its revenue as net profit after accounting for all expenses and taxes.
- This reflects efficient operations and effective management of expenses.
- Return on Equity (ROE) (80%)
- ABC Enterprises achieves an impressive return on equity of 80%, indicating that it generates significant profits relative to the shareholders' equity invested in the company.
- This suggests efficient utilisation of shareholders' funds to generate returns.
- Current Ratio (2.67) and Quick Ratio (2.17)
- ABC Enterprises has a current ratio of 2.67 and a quick ratio of 2.17, indicating a healthy liquidity position.
- The current assets are more than sufficient to cover its short-term liabilities
- Inventory Turnover Ratio (5.71)
- The inventory turnover ratio of 5.71 suggests that ABC Enterprises efficiently manages its inventory by quickly selling and replenishing stock.
- This indicates effective inventory management and avoids holding excess inventory.
- Accounts Receivable Turnover Ratio (11.43)
- ABC Enterprises has a high accounts receivable turnover ratio of 11.43, indicating that it efficiently collects payments from its customers.
- This suggests:
- Effective credit management and
- Timely collection of receivables
Conclusion
Ratio analysis is a powerful tool that helps in performing a fundamental analysis of a company. It helps investors know about the financial performance of a company which is key to making smart investment decisions.
We can divide ratio analysis into four broad categories with each making different indications. Through liquidity ratios, you can gauge a company's ability to meet its short-term obligations, while profitability ratios shed light on its ability to generate profits from its operations. Solvency ratios provide insights into a company's long-term financial stability, and efficiency ratios offer clues about its operational effectiveness.
By comparing a company's ratios to industry benchmarks, historical trends, and competitors' performance, you can understand which companies to pick and invest in.
Start your SIP investment today and build wealth under the guidance of the best fund managers.
Calculate your expected investment returns with the help of our investment calculators
Investment Calculator | ||
SIP Calculator | Mutual Fund Calculator | Lumpsum Calculator |
Lumpsum Calculator | FD Calculator | Brokerage Calculator |
Frequently asked questions
What do you mean by ratio analysis?
Ratio analysis are fundamental analysis tool. By comparing them with industry benchmarks, you can assess the financial health of a company.
What are the four types of ratio analysis?
Ratio analysis can be divided into four types, which are:
- Liquidity ratios
- Solvency ratios
- Profitability ratios, and
- Efficiency ratios
Where can I find financial data to conduct ratio analysis?
Financial data required for ratio analysis can typically be found in a company's financial statements, including the balance sheet, income statement, and cash flow statement. This information is often available in annual reports, quarterly filings with regulatory authorities, and financial databases.
Can ratio analysis be used for different types of companies?
Yes, ratio analysis can be applied to companies of all sizes and across different industries. However, the choice of ratios and benchmarks may vary depending on the specific characteristics of the company and its industry.
Show More Show Less
Disclaimer
Bajaj Finance Limited (“BFL”) is a Non-Banking Financial Company carrying the business of acceptance of deposits, providing lending solutions to Retail & Corporate customers, and is a Corporate agent of various insurance Companies. BFL is also registeredwith the Association of Mutual Funds in India (“AMFI”) as a distributor of third party Mutual Funds (shortly referred as ‘Mutual Funds’).
BFL does NOT:
(i)provide investment advisory services in any manner or form;
(ii)perform risk profiling of the investor;
(iii)carry customized/personalized suitability assessment;
(iv)carry independent research or analysis, including on any Mutual Fund schemes or other investments; and provide any guarantee of return on investment.
In addition to displaying the Mutual fund products of Asset Management Companies, some general information is sourced from third parties, is also displayed on ‘As-is’ basis, which should NOT be construed as any solicitation or attempt to effect transactions in securities or the rendering any investment advice. Mutual Funds are subject to market risks, including loss of principal amount and Investor should read all Scheme /Offer related documents carefully. The NAV of units issued under the Schemes of mutual funds can go up or down depending on the factors and forces affecting capital markets and may also be affected by changes in the general level of interest rates. The NAV of the units issued under the scheme may be affected, inter-alia by changes in the interest rates, trading volumes, settlement periods, transfer procedures and performance of individual securities. The NAV will inter-alia be exposed to Price / Interest Rate Risk and Credit Risk. Past performance of any scheme of the Mutual fund do not indicate the future performance of the Schemes of the Mutual Fund. BFL shall not be responsible or liable for any loss or shortfall incurred by the investors. There may be other / better alternatives to the investment avenues displayed by BFL. Hence, the final investment decision shall at all times exclusively remain with the investor alone and BFL shall not be liable or responsible for any consequences thereof.
Bajaj Finserv Direct Limited, (“BFDL”), a wholly owned subsidiary of Bajaj Finserv Limited (is a Registered with SEBI as an Investment Advisor with Registration no. INA000016083). BFDL enables resident Indian customers to directly invest in third party mutual funds through its online platform. BFDL entered into a referral arrangement with BFL, whereunder, BFL may, without risk or responsibility on its part, refer the resident Indian customers who are interested in placing their investments in Direct Mutual Funds through BFDL online platform. Investment by a person residing outside the territorial jurisdiction of India is not acceptable nor permitted.
Disclaimer on Risk-O-Meter:
Investors are advised before investing to evaluate a scheme not only on the basis of the Product labeling (including the Riskometer) but also on other quantitative and qualitative factors such as performance, portfolio, fund managers, asset manager, etc. and shall also consult their financial advisers, if they are unsure about the suitability of the scheme before investing
© Bajaj Finserv 2007-2024. All rights reserved.