The comparison of line items in the financial statements, namely Trading and Profit or Loss Account, Balance Sheet and CFS (Cash Flow Statements) of a business, is Ratio Analysis. This analysis evaluates several issues within an entity, such as Coverage, Liquidity, Profitability and such.
Analysts, Creditors or Potential Competitors mainly use this type of analysis since their primary and only source to obtain information on a company is through financial statements. The company’s management also uses Ratio Analysis to improve its understanding of financial results and trends over time and provide organisational performance indicators.
Ratio Analysis is employed in the following two ways:
- Trend Analysis
- Competitor Analysis
This analysis helps to understand a business better, compare and optimise the performance over a period.
1) Trend Analysis:
Calculating ratios over many reporting periods, following the reporting regulations and turning them into percentages to compare them with each other is trend analysis. Trend Analysis is a tool used by the management to analyse the company’s monetary statements for investment purposes.
The figures are converted into percentages for comparison purposes,
Trend Analysis Percentage = ( Previous period figure – Current period figure)/Total of both figures.
Trend Analysis, the calculation of trends is based on past data and is favourable in deducing the company’s current status and optimising financial literacy among the management.
2) Competitor Analysis:
Calculating the same ratios for the competitors in a similar industry and comparing your company’s results can determine the performance. Since most businesses from a similar industry operate on a similar Fixed Asset and Capital Structure, the ratio analysis results should be similar.
If that is not the case, it indicates a potential fault or issue in your company’s performance or the reverse – your company’s performance is higher than your competitor companies in the industry. The Competitor Analysis method is used to address which businesses in an industry are most or least performing.
Various businesses in the industry use different kinds of ratios to analyse their company’s performance. The major categories of Ratio Analysis types are listed below;
Various Ratio Analysis categories:
- Liquidity Ratios
- Profitability Ratios
- Solvency Ratios
- Efficiency Ratios
- Coverage Ratios
There are multiple ratios under each category, each used in a specific company for a specific reason:
1) Liquidity Ratios:
Liquidity is the ability to convert assets quickly into cash. Liquidity Ratios are used to determine a company’s ability to pay off its short-term finances in case of a company’s liquidation. Prospective creditors and lenders most commonly use these ratios to decide if to lend or extend their credit or debt, respectively.
Few vital liquidity ratios are;
- Current Ratio
- Quick Ratio
- Cash Ratio
2) Profitability Ratios:
Profitability ratios are measures to assess the business’s ability to make or create revenue or profits from its current sales revenue or operating revenue, balance sheet assets or shareholders’ equity, over time, using data from a specific point 0f time.
It indicates how efficiently a company can generate profit and value for its shareholders.
For most profitability ratios, having a more significant or higher value than the industry average indicates the company is doing well. Profitability Ratios are most useful compared to similar companies or history of the company or average of the industry. They generally fall under two categories: Margin Ratios and Return Ratios.
- Profit Margin
- Gross Profit Margin
- Pre-Tax Margin
- Operating Margin
- Return on Assets
- Return on Investments
- Return on Capital Employed
- Return on Equity
These ratios are used continuously to better the company’s performance and optimise with the industry standards.
3) Solvency Ratios:
Solvency Ratio is the measure to assess a business’s ability to pay off its long term debts and liabilities to have a more extended outlook. It indicates if a company’s cash flow is sufficient to meet its long term liabilities and thus is a measure of financial health. An unfavourable forecast of cashflows and solvency can indicate that the company might fault for paying its liabilities and debt obligations.
The main Solvency ratios are;
- Debt to Assets ratio
- Interest coverage ratio
- Debt-Equity Ratio
These measures are later compared to the liquidity ratio, which considers a firm’s ability to meet its short term obligations rather than medium and long term ones.
4) Efficiency Ratios:
These ratios are used to measure a business’s ability to use its assets and liabilities to generate sales. A highly efficient organisation minimises its net investment in assets and requires less capital and debt to maintain its operations.
Some commonly used Efficiency Ratios are;
- Fixed Asset Turnover
- Inventory Turnover
- Accounts Payable Turnover
- Accounts Receivable Turnover
5) Coverage Ratios:
These ratios are used to measure and assess the ability of a business to meet its debt obligations. Lenders and creditors most commonly use these ratios to review the finances of a prospective or current borrower.
Some commonly used Coverage Ratios are;
- Interest Coverage Ratio
- Debt Coverage Ratio
- Asset Coverage Ratio
Choosing the right Accountancy firm that could provide you with all the insights regarding ratio analysis and incorporating them into your business could be the make or break point for your business.