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Ratio Analysis is a financial tool used to evaluate the performance and financial health of a
business by examining the relationship between different items in its financial statements. It helps
in understanding profitability, liquidity, efficiency, and solvency by converting raw financial data
into meaningful ratios. These ratios provide quick insights for decision-making, comparison with
industry standards, and identifying strengths and weaknesses of a company. By analyzing trends over
time, ratio analysis also supports forecasting and strategic planning, making it a vital tool for
management, investors, and other stakeholders.
Objectives of Ratio Analysis
The main objectives of ratio analysis are to measure the profitability, liquidity, and solvency of a
business. It helps to judge the operational efficiency of resources and enables comparison with past
results or industry standards. Ratio analysis also supports decision-making for management and
investors, highlights strengths and weaknesses, and assists in forecasting and planning for the
future.
Benefits of Ratio Analysis
| *Ratios are easy to calculate and understand. |
*Helps identify areas where resources can be better utilized. |
| *Useful to compare performance over time or with competitors |
*Guides management, investors, and creditors. |
| *Shows how efficiently the business earns profits. |
*Useful for predicting future performance and making strategies. |
| *Indicates ability to meet short-term obligations. |
*Shows financial strong points and problem areas. |
| *Assesses long-term financial stability. |
*Presents financial performance in a clear, summarized way. |
Types of Ratio Analysis
Ratio analysis is a financial tool used to evaluate a company’s performance
and financial health by comparing relationships between different figures in its financial
statements. It is broadly categorized into types like liquidity, solvency, profitability,
efficiency, and market ratios.
Liquidity Ratios
Liquidity ratios measure a company's ability to pay off short-term debts as they become due,
using the company's current or quick assets
- Current ratio
- Quick ratio
- Working capital ratio
Solvency Ratios
Also called financial leverage ratios, solvency ratios compare a company's debt levels with
its assets, equity, and earnings. These are used to evaluate the likelihood of a company
staying afloat over the long haul by paying off both long-term debt and the interest on that
debt. Examples of solvency ratios include:
- Debt-equity ratios
- Debt-assets ratios
- Interest coverage ratios
Profitability Ratios
These ratios convey how well a company can generate profits from its operations. Examples of
profitability ratios include:
- Profit margin ratio
- Return on assets
- Return on equity
- Return on capital employed
- Gross margin ratio
Efficiency Ratios
Also called activity ratios, efficiency Ratios evaluate how efficiently a company uses its
assets and liabilities to generate sales and maximize profits. Key efficiency ratios
include:
- Turnover ratio
- Inventory turnover
- Day's sales in inventory
Coverage Ratios
Coverage ratios measure a company's ability to make the interest payments and other
obligations associated with its debts. Examples include:
- Times interest earned ratio
- Debt-service coverage ratio
Market Prospect Ratios
Market prospect ratios are the most commonly used ratios by investors. Typically, they use
these metrics to attempt to predict earnings and future performance. These ratios include:
- Dividend yield
- P/E ratio
- Earnings per share (EPS)
- Dividend payout ratio
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