Financial Ratio Analysis

Financial Ratio Analysis

Investors, creditors and internal company management uses certain financial ratios to analyze where a business is standing financially. Some of the most commonly used financial ratios are:

  • Current Ratio → It is a liquidity ratio that shows a company’s capability to pay-off its short term liabilities using its current assets. Current ratio is obtained by dividing the company’s current assets by its current liabilities. A high current ratio is always preferred because it shows the company can pay off its debts easily.

  • Quick Ratio (Acid Test) → This ratio shows a company’s ability to pay off its current liabilities, only using quick assets such as cash, cash equivalents, short term investments and current accounts receivables. Quick ratio is obtained by dividing a company’s above mentioned quick assets using its current liabilities. A higher quick ratio means the company has more quick assets than current liabilities and such a value is favoured.

  • Debt to Equity Ratio → This ratio compares a firm’s overall debt to overall equity. It is calculated by dividing total debt (liabilities) by total equity. If the debt ratio is 0.5, it means that the company has half as many liabilities as there is equity. If it is 1, it means the debt and equity portion are equal. As the debt to equity ratio gets lower, it indicates that the business is more financially stable.

  • Total Outside Liabilities Ratio → This ratio gives a measure of the company’s financial leverage and is obtained by dividing the total liabilities of the firm by the firm’s total net worth. Total outside liabilities is the sum of all the liabilities the firm has and net worth is the sum of share capital and surplus reserves of the firm. If the ratio is low, it indicates that there is a good level of promoters’ stake in the business.  

  • Inventory Turnover Ratio → It is an efficiency ratio that measures how efficiently the inventory is managed in the firm. The ratio shows how many times, on average, the inventory is sold during a particular period. The inventory turnover ratio is calculated by dividing the cost of goods sold by the average inventory. As the ratio goes to high values, it denotes that the company can sell its inventory effectively. However, the turnover value varies with the industry in which the firm operates.

  • Accounts Receivable Turnover Ratio → This ratio shows how many times a business can collect its average accounts receivable during a specified period, usually a year. It is obtained by dividing the net credit sales of the company by its average accounts receivable. A higher receivables turnover ratio is preferred since it shows that the business is capable of efficiently collecting its receivables.

  • Debtors’ Collection Period → This ratio indicates the average time it takes a firm to collect its debts. It is obtained by dividing average debtors by credit sales and then multiplying the result with 365. A low value is preferred for this ratio as it means the firm collects the debts frequently.

  • Net Profit to Sales ratio → It is the ratio profit-after-tax to net sales. This ratio is widely used to assess the overall results of a company in terms of how well it is utilizing its working capital. To study whether or not  the firm has improved its profitability, analysts compare current year’s ratio with that of previous year and industry’s average.

  • Return on Equity Ratio → RoE measures how capable a firm is in generating profit from its shareholders investments. It is obtained by dividing net income by shareholders’ equity. A high RoE is preferred as it indicates that the firm is efficiently using its investors fund.

  • Return on Investment → This ratio evaluates the efficiency of an investment or it is the measure of return on an investment against the investment’s costs. It is calculated by finding the difference between the gain from the investment and cost of investment and then dividing the result with cost of investment. If an investment shows a positive RoI, it sends a favourable signal to the investor.