Financial analysis plays a vital role in making business and investment decisions. It helps to evaluate the financial health and performance of the organisation. One of the key components of financial analysis is ratio analysis.

Ratios provide a better understanding of the financial statements by relating the numbers within them. These ratios can be classified into five major categories- Liquidity Ratios, Solvency Ratios, Profitability Ratios, Efficiency Ratios, and Valuation Ratios. Understanding and analysing these ratios is essential to make informed financial decisions.

## Liquidity Ratios

Liquidity ratios are used to measure the ability of the company to meet its short-term obligations. The liquidity of a business is the degree to which it can convert its assets into cash to pay its debts. Liquidity ratios provide an overview of the company’s ability to meet its short-term debts.

### Current Ratio

The current ratio is a liquidity ratio used to measure the company’s ability to meet its short-term obligations. It is calculated by dividing the total current assets by total current liabilities. The ideal current ratio is 2:1, which means that the company has twice the amount of current assets than liabilities. A current ratio of less than 1 indicates that the company may face short-term liquidity issues.

### Quick Ratio

Quick Ratio, also known as Acid Test Ratio, is a liquidity ratio used to measure the company’s ability to pay its short-term debts without relying on the sale of inventory. It is calculated by dividing the total current assets minus inventory by total current liabilities. The quick ratio helps determine a company’s ability to pay off its current liabilities quickly. A Quick Ratio of 1:1 is ideal for a company.

## Solvency Ratios

Solvency ratios measure the ability of the company to meet its long-term obligations. Solvency ratios provide insight into the company’s financial health by determining the extent to which its assets can cover its long-term debts.

### Debt to Equity Ratio

The Debt to Equity ratio is a solvency ratio used to measure the proportion of debt and equity in financing the assets of the company. It is calculated by dividing the total liabilities by the total shareholders’ equity. The ideal Debt to Equity ratio is 1:1. A higher ratio indicates that the company relies more on borrowing to finance its assets.

### Interest Coverage Ratio

Interest Coverage Ratio is a solvency ratio used to measure a company’s ability to pay its interest expense. It is calculated by dividing the company’s earnings before interest and taxes (EBIT) by interest expense. A higher Interest Coverage Ratio indicates that the company can easily cover its interest expenses with the available earnings.

## Profitability Ratios

Profitability Ratios measure the company’s ability to generate profits relative to its sales, assets, and equity. It helps to evaluate the performance of the company and its overall profit margins.

### Net Profit Margin Ratio

Net Profit Margin Ratio is a profitability ratio used to measure the company’s profitability after accounting for all expenses. It is calculated by dividing the net profit by total revenue. A higher Net Profit Margin Ratio indicates that the company is more profitable.

### Return on Equity Ratio

Return on Equity Ratio is a profitability ratio that measures the return on investment for shareholders. It is calculated by dividing the net profit by total shareholders’ equity. The higher the ratio, the more return the shareholders are receiving on their investment.

## Efficiency Ratios

Efficiency ratios are used to measure the effectiveness and efficiency of the company’s operations. It helps to evaluate how well the company uses its assets and liabilities to generate income.

### Inventory Turnover Ratio

Inventory Turnover Ratio is an efficiency ratio that measures how quickly the company is selling its inventory. It is calculated by dividing the cost of goods sold by the average inventory. A higher Inventory Turnover Ratio indicates that the company is effectively managing its inventory levels.

### Accounts Receivable Turnover Ratio

Accounts Receivable Turnover Ratio is an efficiency ratio used to measure how quickly the company is collecting its receivables. It is calculated by dividing the total credit sales by the average accounts receivable. A higher Accounts Receivable Turnover Ratio indicates that the company is more efficient in collecting its receivables.

## Valuation Ratios

Valuation Ratios are used to determine the value of the company’s stock relative to its earnings, sales, and assets.

### Price to Earnings Ratio

Price to Earnings Ratio is a valuation ratio that measures the company’s share price relative to its earnings. It is calculated by dividing the current market price per share by earnings per share. A higher Price to Earnings ratio indicates that investors are willing to pay more for the stock.

### Price to Sales Ratio

Price to Sales Ratio is a valuation ratio used to measure the company’s share price relative to its sales. It is calculated by dividing the current market price per share by sales per share. A higher Price to Sales Ratio indicates that investors are willing to pay a premium for the company’s sales.

## Conclusion

Reading ratios is an essential part of financial analysis. It helps to evaluate the strengths and weaknesses of a business and to make informed decisions. By understanding these ratios, you can gain a better understanding of the company’s financial position and performance.

- What are ratios?
- Ratios are used in which categories of financial analysis?
- How many categories of ratios are there?
- What is the current ratio?
- What is the quick ratio?
- What is the debt to equity ratio?
- What is the interest coverage ratio?
- What is the net profit margin ratio?
- What is the return on equity ratio?
- What is the inventory turnover ratio?
- What is the accounts receivable turnover ratio?
- What is the price to earnings ratio?
- What is the price to sales ratio?
- What are the ideal current ratios and quick ratios?
- What do higher ratios indicate?

References:

- Gitman, L. J., & McDaniel, C. D. (2008). The Future of Business: The Essentials. South Western Cengage Learning.
- Brigham, E. F., & Houston, J. F. (2013). Fundamentals of Financial Management. South-Western College Pub.
- Bhattacharya, H. (2011). Financial Management: Principles and Practice. Pearson Education India.