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# Guide to ratio analysis and its application

Ratio analysis is used to examine many aspects of a company like profitability, liquidity, and operational efficiency by evaluating financial documents like the balance sheet and income statement.

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The fundamental study of a company’s equity begins and ends with ratio analysis.  The performance of a company over time can be measured via ratio analysis, and the results can be compared to the performance of other companies in the same market or sector.

## Ratio Analysis: Different types of financial ratios

Numerous financial ratios are used in the process of ratio analysis. These ratios can be broken down further into the following categories:

### Liquidity ratios

The liquidity ratio measures a firm’s capacity to satisfy its debt commitments with its current assets. When a firm is facing financial problems and is unable to pay its bills, it may convert its assets into cash and utilise the funds to satisfy any outstanding debts. The fast ratio, the cash ratio, and the current ratio are examples of popular liquidity ratios. Banks, creditors and suppliers use liquidity measures to evaluate if a customer can meet their financial commitments when they become due.

### Profitability ratios

The capacity to generate profits in relation to the costs connected with running the company is what profitability ratios attempt to quantify. Recording of a greater profitability ratio than the last financial reporting periods indicates financial progress. The profitability ratio of a business may also be compared to the profitability ratio of a comparable company to evaluate how profitable the business is in comparison to its rivals. The return on equity ratio, the return on assets ratio, the profit margin, the gross margin, and the return on capital employed are examples of essential profitability ratios.

### Solvency ratios

Solvency ratios are a measurement of a company’s capacity to remain financially viable over the long term. The amounts of a company’s debt concerning its assets, equity, or yearly profits are measured. The debt to capital ratio, the debt ratio, the interest coverage ratio, and the equity multiplier are some of the most important solvency ratios. The majority of users of solvency ratios are government agencies, banks, workers, and institutional investors.

### Market prospect ratios

Investors can estimate the amount of money that can be made, by using market prospect ratios. Earnings might be taken in the form of a greater stock value or dividend payments in the future. Investors may use the company’s present profits and dividends as a basis for estimating the likely future stock price and the dividends they can anticipate receiving from the company. The dividend yield, earnings per share, the price-to-earnings ratio, and the dividend payout ratio are some important market prospect measures.

### Coverage ratios

The capacity of a company to pay its debts and fulfil its other responsibilities can be evaluated using coverage ratios. The coverage ratios over a number of reporting periods can be used by analysts to construct a trend to make predictions about the company’s financial status in the future. If a company has a high coverage ratio, it indicates that the company can pay its debts and the responsibilities related to them. The debt coverage ratio, the interest coverage and the fixed charge coverage  are some of the most important coverage ratios.

### Efficiency ratios

A company’s ability to create sales and profits can be measured using efficiency ratios, which indicate how effectively the company is using its assets and liabilities. They compute the turnover of liabilities, the consumption of equity, and the utilisation of inventories and equipment. If there is an increase in the efficiency ratios, the company would see an increase in both its sales and its profits. The asset turnover ratio, the inventory turnover, the payables turnover, the working capital turnover, the fixed asset turnover, and the receivables turnover ratio are some of the most essential efficiency ratios.

## Several applications of ratio analysis

### Trend line

Ratio analysis can be used by companies to determine a pattern in the financial performance of the company. Data from the company’s financial statements are compiled over many reporting periods by well-established businesses. The obtained trend can be used to predict the direction of future financial performance and identify financial turbulence. In addition, the trend can be used to determine any unexpected financial turbulence.

### Operational efficiency

A company’s management can use ratio analysis to measure the degree of efficiency in the management of assets and liabilities done by the management of the company. When assets like vehicles, land, and buildings are used inefficiently, it results in wasteful costs. Utilising financial ratios is another way to know if the available financial resources are being over-or under-utilised.

### Comparison

One of the applications of ratio analysis is to make a comparison of the financial performance of businesses between companies. A method that assists management in determining market gaps and analysing the company’s competitive advantages, strengths, and weaknesses is to get financial ratios from Price/Earnings, and then compare them to the company’s own ratios. Following this, the management of the firm may make choices to strengthen the company’s position in the market.

`Source: https://ecis2016.org/.Copyright belongs to: ecis2016.org`

Source: https://ecis2016.org
Category: Must Knows

### Debora Berti

Università degli Studi di Firenze, IT