What role does ratio analysis play for analysing a company?

Ratio analysis is the analysis of various parts of financial information in the financial statements of the company. It is mainly used by external analysts to analyse a company based on its profitability, liquidity & solvency. Nowadays, determining the financial health of a company is considered a crucial part of fundamental analysis. This fundamental analysis is done for various reasons, ranging from making an investment into any company to merging or acquiring any company, etc. Both the current as well as the past data are used by the analysts to analyse the financial health of the company, whether it’s upward or downward, and also, helps to compare the company with its peers based on the performance.   

Below are some of the advantages of ratio analysis:  

1) Comparisons: 

Ratio analysis helps to understand where do the company stands in the market as compared to its peers. This also helps the management to identify gaps and do a SWOT analysis of the company i.e. strength, weaknesses, opportunities, and threats. The management can then formulate decisions, accordingly, based on the information gathered from the ratio analysis.  

 2) Trend line:  

The company can use ratio analysis to identify if any trend has been established for the financial performance of the company. The established companies gather data over a large number of reporting periods. The future financial performance of the company can be predicted using ratio analysis and also where any forthcoming financial turbulence is sensed. 

3) Operational efficiency:  

The ratio analysis is also used by the management the degree of efficiency in the management of assets and liabilities. The over-utilisation and underutilisation of financial resources can also be monitored using the financial ratio analysis.   

The financial ratios can be categorised into the following categories: -  

1) Liquidity ratios

Liquidity ratios basically measure a company’s ability to meet its debt obligations using its current assets. Current assets are all the assets of a company that are expected to be sold or used as a result of standard business operations over the next year. At the time of financial difficulties, the company converts its assets into cash and settles the pending debts using the cash generated. Some of the common liquidity ratios are:  

• Current ratio = Current assets/current liabilities   

Where current assets = cash, cash equivalents, accounts receivable, stock inventory, marketable securities, pre-paid liabilities & other liquid assets while current liabilities= accounts payable, short-term debt, dividends, and notes payable, as well as income taxes, owed.

• Quick ratio or acid test ratio = Quick assets/current liabilities   

Where quick assets = cash & equivalents + marketable securities + accounts receivables  

• Cash ratio = (cash + marketable securities)/current liabilities 

2) Solvency ratios

Solvency ratios are used to measure a company’s long-term viability. While using the solvency ratios, the company’s debt levels are compared to its assets, equity, or annual earnings. These ratios are primarily used by governments, banks, employees, and institutional investors. The important solvency ratios are:  

• Debt ratio = Total debt/total assets  

This ratio helps to determine the company’s risk level.

• Debt-to-capital ratio = Debt/debt + shareholder's equity  

This ratio helps in understanding the financial structure of the company and whether it is a good investment or not. Higher the ratio, the riskier the investment.  

• Interest coverage ratio = EBIT/interest expense during the period  

Where EBIT = earnings before interest & taxes .

This ratio tells the company’s ability to easily pay interest from the generated EBIT. The higher the ratio, the better is the position of the company.  

• Equity multiplier = Total assets/total stockholder’s equity  

This ratio measures the number of a firm’s assets that are financed by its shareholders. In other words, it also shows how much debt financing the company has used to acquire assets and maintain operations. It is an indication of the company’s risk to the creditors.  

3) Profitability ratios  

Profitability ratios measure the ability of businesses to earn profits in comparison to their associated expenses. A higher profitability ratio as compared to past periods can portray that the business is improving financially. Examples of profitability ratios include:  

• Return on equity ratio (ROE) = Net income/shareholder's equity  

ROE measures the profitability of the organisation in relation to the stockholder’s equity.   

• Return on assets (ROA) = Net income/total assets  

ROA tells how profitable the company is as compared to its total assets.  

• Net profit margin = Net profit/sales  

Higher the ratio, the better the performance of the company.  

• Return on capital employed = EBIT/capital employed  

Capital employed is calculated as (total assets – current liabilities) i.e., the total amount of equity invested in the business. This ratio tells us how efficiently the company is using its capital to generate profits.  

4) Efficiency ratios

Efficiency ratios tell us how well the business is using assets & liabilities to generate its sales and earn profits. Some important efficiency ratios are:  

• Asset turnover ratio = Net sales/average assets  

The ratio helps in understanding how effectively assets are used in generating sales.  

• Inventory turnover = Net sales/average inventory   

Inventory turnover measures how many times in a given period a company is able to replace the inventories that it has sold.  

• Payable turnover ratio = Credit purchases/average payables  

This is an important ratio in understanding how effectively the company is managing its payables and suppliers.  

• Working capital turnover = Net sales/average working capital   

Working capital turnover depicts how effective a business is at generating sales for every dollar of working capital put to use.  

5) Coverage ratios 

Coverage ratios throw light on the company’s ability to service its debts and other obligations. A higher coverage ratio displays that a business can service its debts and associated obligations with better ease. Following is the important coverage ratios:  

• Debt service coverage ratio (DSCR) = Net operating income/debt service coverage ratio  

DSCR is the measurement of a firm's available cash flow to pay current debt obligations.  

• Fixed-charge coverage ratio (FCCR) = (EBIT + FCBT)/ (FCBT + interest)  

Where, EBIT = Earnings before interest & taxes and   

FCBT= Fixed charges before taxes  

FCCR tells us regarding the firm's ability to cover its fixed charges, such as debt payments, interest expense, and equipment lease expense.  

• EBITDA coverage ratio = (EBITDA + lease payments) / (interest payments + principal repayments + lease payments)  

Where, EBITDA = Earnings before interest, depreciation & taxes  

EBITDA coverage ratio studies the ability of a company's EBITDA to pay annual financial obligations.  

6) Market prospect ratios

Market prospect ratios assist investors in predicting how much they will earn from specific investments. The earnings can take the form of higher stock value or future dividends. The key market prospect ratios are:  

• Dividend yield = Annual dividends per share/current share price  

Historical evidence suggests that focus on dividends may expand returns rather than slow them down.

• Earnings per share (EPS) = Net income/total number of outstanding shares  

EPS indicates the profitability of the company and hence is considered a crucial indicator.  

• Price-to-earnings ratio (PE ratio) = Market price of share/earnings per share  

PE ratio shows what the market is willing to pay for a company’s profits. It helps to conclude if the share is overvalued or undervalued.   

• Dividend payout ratio = Dividends paid/net income  

The dividend payout ratio helps the investors in knowing the dividend sustainability of a company.