Financial Ratio Analysis

Ratio Analysis

Ratio analysis is a financial technique for evaluating a company's financial health and performance by comparing its financial ratios to industry averages or those of other companies. Ratios are calculated from historical data, such as income statements, balance sheets, and cash flow statements. By comparing ratios within these categories, analysts can identify useful information about the company's financial performance.

Liquidity Ratios

Liquidity ratios are used to assess a company's ability to pay its short-term obligations. Key liquidity ratios include:

• Current Ratio: This measures a company's ability to pay off its current liabilities using only its most liquid assets, typically defined as those which could be converted into cash quickly. It is calculated as current assets divided by current liabilities. A higher ratio indicates better liquidity position.

• Quick Ratio (Acid Test): Similar to the current ratio, but more conservative because it excludes inventory, which may take longer to convert into cash than other current assets. It is calculated as quick assets (current assets - inventory) divided by current liabilities. A higher ratio indicates better liquidity position.

• Cash Ratio: This measures a company's capacity to meet its immediate debts through available cash. It is calculated as cash and equivalents divided by total liabilities. Higher values indicate lower risk levels.

Profitability Ratios

Profitability ratios evaluate how efficiently a company generates profits relative to its revenue. Some key profitability ratios are:

• Gross Profit Margin: This measures the total sales revenue minus cost of goods sold divided by total sales revenue. It indicates how much gross profit one can make on each dollar of sales.

• Operating Income Ratio: Operating income (EBIT) divided by net income shows how effective a company's management is managing expenses to increase profits.

Efficiency Ratios

Efficiency ratios measure a business' operation efficiency and effectiveness. They focus on operating costs relative to revenues. Some important efficiency ratios include:

• Asset Turnover Ratio: This compares a company's net sales with its total assets, indicating how effectively a company uses its assets to generate revenue.

• Total Capital Turnover: Also known as the return on investment ratio, this indicates how many times capital has been turned over during an accounting period. A higher value implies that the company is more efficient.

Leverage Ratios

Leverage ratios show a company's debt load relative to its equity and earnings. Important leverage ratios are:

• Debt to Equity Ratio: This measures the proportion of shareholder funds used for financing operations compared to those provided by creditors. Debt-equity ratios greater than 1 indicate more reliance on borrowed funds.

• Debt Ratio to Net Worth: This measures the percentage of a firm's stockholders' equity represented by long-term debts.

Investment Ratios

Investment ratios assess a company's ability to invest in future growth opportunities. Key investment ratios are:

• Capital Expenditure (CAPEX) Ratio: This shows how much capital expenditures were in relation to depreciation and amortization. A high CAPEX ratio suggests that a company may need additional funding for new projects.

By analyzing these various financial ratios, investors and analysts can gain valuable insights into a company's financial health, performance, and potential risks. Additionally, comparing ratios across different time periods or industries can provide an even clearer perspective on a company's financial trends and standings.