Ratio analysis is the most commonly used analysis to judge the financial strength of a company. Ratio analysis isn’t just comparing different numbers from the balance sheet, income statement and cash flow statement. It’s comparing the number against previous years, other companies the industry or even the economy in general. Ratios look at the relationships between individual values and relate them to how a company has performed in the past, and might perform in the future.
Ratios are highly important profit tools in financial analysis that help financial analysts implement plans that improve profitability , liquidity , financial structure , reordering , leverage and interest coverage. Although ratios report mostly on past performances , they can be predictive too, and provide lead indications of potential problem areas.
While doing ratio analysis of the data available, it is necessary to keep in mind that a single ratio can never give the complete picture. It is also necessary to remember that a single year’s data may not always give the right picture of the financial health of the company. Lastly, when one is trying to analyze the financial data of two companies with a view of making a comparison or drawing conclusions one needs to take into account whether both the companies have the same year ending.
Key ratios which are usually analyzed are listed below:
Profitability ratios: Profitability ratios speak about the profitability of the company. Typical ratios that are considered to be measures of profitability are the ratios which measure the margins earned in the business and the returns earned. The chief among them are:
Gross Profit Margin which is calculated as:
Gross Profit margin = Gross Profit / Sales
This ratio is an indicator of the ability of the business to control its production costs or to manage the margin it makes on products it buys and sells. Whilst sales value and volumes may move up and down significantly the gross profit margin is usually quirt stable in percentage terms). However, a small increase (or decrease) in the profit margin, however caused can produce a substantial change in the overall profits.
Operating Profit is calculated as:
Operating Profit / Sales
This ratio is an indicator of the ability of the business to control its other operating costs or overheads.
Net Profit margin, is calculated by dividing the Net Profit by the sales for the sales for the said period. Thos ratio would invariably represent he bottom line profitability of the business.
Return on capital employed (ROCE) which is calculated as:
Net profit before tax, interest and dividend (EBIT) / total assets or total assets less current liabilities
This ratio is considered to be a measure of the efficiency of the business as it takes into consideration the returns that the management has made on the resources made available tot hem, before making any distribution of those returns.
As obvious from the name, the higher the profitability ratios, the better for the company
Liquidity ratios: These ratios are used to judge the short term solvency of a firm. These ratios give an indication of how liquid a firm is. The most commonly used ratios are – Current ratio and the quick ratio.
Current ratio = Current Assets / Current Liabilities
This ratio is a simple measure that estimates whether the business can pay debts due within one year from assets that it expects to turn into cash within that year. A ratio of less than one is often a cause for concern, particularly if it persists for any length of time.
Quick Ratio (or Acid test ratio) The Quick Ratio adjusts the Current Ratio to eliminate all assets that are not already in cash (or in near-cash) form. Once again a ratio of less than one would start to send out danger signals.
This ratio is calculated by adding Cash + Accounts Receivable / Current Liabilities
Financial Leverage ratios
These ratios are used to judge the long term solvency of a firm. The most commonly used ratios are – Debt equity ratio (total debt divided by total equity) and long term debt to equity ratio (long term debt divided by equity). While the accepted norm for debt equity ratio differ form industry to industry the usual accepted norm for Debt / Equity (D/E) is 2:1
1) Debt Equity ratio = Long term debt / Total equity
2) Long term debt to total equity ratio = Long term debt / total long term capital
Earnings Coverage ratios: There are several ratios commonly used by investors by assess the performance of a business as an investment. Some of these are:
Earnings per share (EPS) = Earnings (Profits) attributable to ordinary shareholders / Weighted average of ordinary shares in issue during the year.
EPS measures the overall profit generated for each share in existence over a particular period.
Price Earnings Ratio (P/ E Ratio) = Market price of share / Earnings per share.
At any time, the P/ E ratio is an indication of how highly the market rates or values a business. A P/ E ratio is best viewed in the context of a sector or market average.
Dividend Yield = (Latest dividend per ordinary share / current market price of share) x 100 a dividend payment. It also measures the proportion of earnings that are being retained by the business rather then distributed as dividends.