A company prepares its financial statements at the end of the year to study its financial performance. However, interpreting them is not a piece of cake for every stakeholder. It requires complete knowledge of every aspect of accounting and financing. Financial ratio analysis offers a straightforward interpretation of complex numbers. It is a powerful tool that gives insight into the execution of the plans set. It dives deep into the efficiency, profitability, flexibility, and sustainability of the firm.
Financial ratio analysis comprises elements from the balance sheet and income statement. Every ratio gives an idea of whether you lack or excel in that area. There are some standards set for some ratios, while for others, it is context-specific.
Why Do We Use Financial Ratios?
Financial Ratios Offer The Following Uses:
A simplified interpretation of statements:
Financial ratio analysis uses elements from income and position statements and converts them into ratios. It gives a glimpse of the relationship between the balance sheet and profit and loss accounts in an easy-to-read manner.
Detection of threats:
A business is subject to various threats and opportunities in its life. Thus, it becomes vital to detect these at the earliest and prepare for them. Analyzing the critical ratios over time will give you an insight into the deterioration or success of the firm.
Comparison with competitors:
Ratios facilitate comparison with other firms in the industry. There is a benchmark set for various ratios. Also, the industrial averages provide a standard format for matching. It allows you to know where you stand among others.
Choosing appropriate financial ratios-
There are several ratios available for businesses to analyze. But, they must choose the ratios that align with their goals and objectives. For example- if they want to increase their profitability, they should study the considerable profit margins. The financial ratio analysis falls under the following categories:
Profitability ratios: It measures the performance of the firm in a specific period. These include items from the income statement like gross profit, operating profit, net profit, and others.
Efficiency ratios: These ratios measure the growth rate generated by the assets of the company. These comprise balance sheet items like inventory ratio, payables or receivables, etc.
Liquidity ratios: It indicates the company’s ability to pay the current debt obligations. The examples include current ratio, quick ratio, etc.
Leverage ratios: It shows the percentage of debt financing in the company’s overall financial structure.
Here is a list of some significant ratios and their formulae for businesses to consider for their financial performance:
Gross profit ratio:
A gross profit ratio is simple and easy to calculate. It lets the company know the profit margin per unit sold. Its formulae comprises:
Gross Profit Ratio= Gross revenue ( Total revenue- Cost of goods sold)/ Total revenue*100
A company can also use Net profit ratio. The formula remains the same except, we also subtract administration and selling expenses from gross profit. It reflects the actual gain of a company. The higher the ratio, the better the outcome for a firm.
Return on assets:
It is a hybrid ratio comprising items from both the balance sheet and income statement. Its formula is:
ROA= Net Income/ Total Assets*100
It reflects the gains from the assets employed by the company. Both the investors and internal management benefit from this ratio as it gives them an idea about the firm’s efficiency. A higher return suggests that the firm is earning more with less investment. However, an extremely high ratio highlights some errors or fraud in the statement.
Return on investment:
As suggested by the name, this ratio reflects the profits received from the investments. Formula:
ROI= Earnings for the period/Initial investment*100
A company starts gaining from its investment usually after one or two years, depending upon its nature. The experts prefer it to be a minimum of 10% for fund growth. However, it may vary based on the different factors affecting it.
Quick and current ratio:
These liquidity ratios reflect the company’s ability to pay the current debt obligations. The current ratio has a wider scope as it includes the total of current assets and liabilities. The benchmark for this ratio is 2:1, which means the current assets must be double of current liabilities.
Current ratio= Current assets/Current liabilites
The quick ratio, on the other hand, excludes inventory and prepaid expenses. It shows whether the company can pay the immediate debt obligations or not. The ideal quick ratio is 1:1.
Quick ratio= Quick assets/Current laibilites
Higher than the benchmark is not necessarily healthy because it can reflect improper use of assets.
Debt to equity ratio:
A financial leverage ratio calculates the total debt in comparison to the total assets of the firm. It determines how much of a company’s assets are being financed by a third party.
Debt to equity ratio= Total liabilities/ Shareholder’s equity
A company should keep it less than one for better financial health.