Have you ever performed a ratio analysis to measure a company’s performance? Ohh, it is sad to hear that you have heard about this analysis for the first time. Let me explain this analysis in simple language. Many companies around the world perform ratio analysis to know about their profitability, liquidity, and relevancy. Maybe now you remember that you have done this in engineering management class. Well, today’s article is all about this crucial analysis. It will discuss all its types and uses in detail. But before moving on further, let’s define this analysis first.
What is ratio analysis?
The analysis of numerous pieces of financial information in a company’s financial statements is known as ratio analysis. Every company publishes its financial statement quarterly or yearly. The external business analysts make the company’s financial analysis based on past and recent statements. They use these statements to tell whether the company is going in profit or loss. All the crucial information like profitability, liquidity, and solvency is extracted by making this analysis. It means that this analysis is very useful in terms of the accounting and financial stability of a company. If you are working on this analysis and are unable to work on it, you can hire the finance dissertation writing services of The Academic Papers UK.
Uses of ratio analysis
After the information above, it can be inferred that this analysis is very important for companies. There are numerous uses of this analysis. A brief description of those uses is as follows;
One of the uses of this analysis is that it compares the company’s financial health with its competitors. Knowing the financial ratios of other competitor companies helps the managers know the market gaps. They get to know in which area they have to perform better to surpass their competitors.
Companies also perform ratio analysis to see if there is any trend in their performance. Established companies collect data from their previous financial statements and analyze that data. By doing so, they identify different trends. The trend obtained from the analysis is then used to make future plans and predictions about the company’s growth.
What are the five types of ratio analysis?
Evaluating the business performance is a must for every company to keep itself alive in the market. To evaluate it better, a company has to perform a ratio analysis on several financial elements. Therefore, this analysis is divided into five different types. A brief description of each type of analysis is as follows;
This type of analysis tells that returns are generated from the business with the capital invested. In simple words, this ratio measures a business’s ability to earn profits. The higher profitability ratio shows that the business is making money well. You can also compare this ratio of your company with the other company to know how well you are performing. Some important ratios that come under this type of analysis are;
- Gross profit ratio: Represents the operating profit after adjusting the cost of goods
- Net profit ratio: Represents the overall profitability of the company after adjusting all expenses and costs
- Operating profit ratio: Represents the soundness of the company to pay its debts
This type of ratio analysis measures the company’s ability to pay off its debts. It tells whether the company is solvent enough to pay off the debts of lenders or not. In this analysis, the companies compare the debt level to their assets, equity, or annual earnings. It is because these are the things through which companies can pay off their loans. Some important solvency ratios are as follows;
- Debt to equity ratio: Represents the company’s leverage.
- Interest coverage ratio: Represents how many times the company’s profits are capable of paying the interest.
It is the most important type of analysis in all the ratio analysis types. It measures a company’s ability to meet its short-term obligations using its current assets. The liquidity is also called the cash in hand. When a company feels it difficult to pay debt with cash, it can convert the assets into cash and pay its debts. Some common liquidity ratios are as follows;
- Current ratio: Represents the company’s ability to meet its debt obligations in the next 12 months.
- Quick ratio: Represents how cash-rich the company is to pay off its immediate short-term debts.
This type of ratio analysis tells how efficiently the company is using its assets and liabilities to generate revenue. An improvement in turnover ratios means an improvement in the company’s overall financial performance. It is why measuring these is very important. Some important turnover ratios are as follows;
- Fixed assets turnover ratio: Represents the efficiency of the company to generate revenue from its assets.
- Inventory turnover ratio: Represents the company’s ability to covert its inventory into sales.
Every operating company has some shareholders and investors. This type of ratio analysis tells about the profits that the company generates for its investors. Some prominent ratios that come under this are as follows;
- Earnings per share: Represents the monetary value of the earnings of each shareholder.
- Return on net worth: Represents how much profit the company has generated from its capital and investor’s money.
What can three types of comparison be made while doing ratio analysis?
Ratio analysis is necessary to know about the company’s overall financial health. While doing this analysis, you can make several types of comparisons. The three types of comparisons are as follows;
- Comparison to Competitor. In this comparison, you compare the ratio values of your company with other companies. It helps you in getting an idea of your gap areas.
- Comparison to Prior Period. This analysis allows you to make your comparison with the prior period values. This way, you draw a trend line and know about your company’s performance.
- Comparison to Industry Average. In this comparison, you compare your values with the industry average. It allows you to figure out where your company is standing in the market.
Ratio analysis is an important analysis to analyze the growth of a company. You can make use of the types mentioned above to run a financial analysis of your company.