Evaluating different aspects of a company's financial health and performance is a crucial step to maintaining its stability. A technique of financial ratio analysis can be used to compare two or more items of financial data from the financial statements of the company. In this article, we are going to explore what is financial ratio analyses, types and develop an understanding through examples.

What is Financial Ratio Analysis?

Financial ratio is a type of calculation used for evaluating the financial wellbeing of a company by analyzing its financial statement. These ratios let you analyze the company's performance by numbers over time against industry standards. Financial ratios include some main categories, like Liquidity ratios, to measure the ability of a company to meet its short-term debts.

Solvency ratios assess the ability of a company to handle long-term obligations and its overall debt levels. Efficiency ratios determine how well a company can use its assets to generate maximum revenue. Profitability ratios show the ability of a company to generate profits from its operations.

Valuation ratios determine if a company's stock price is under or overvalued as compared to financial metrics. You can determine a company's health and well-being by comparing these ratios with the company's averages. A clear image of the company's financial health is provided with the help of these ratios.

How financial ratio analysis work?

Financial ratio analysis collects data about the company from its financial statements to understand its financial health, efficiency, and profitability. Then, it calculates and interprets these ratios with the company's financial data. Key ratios like liquidity, solvency, Turnover, profitability, and valuation are calculated by the analysts.

They are collected by using line items from balance sheets, cash flow statements, and income statements. The financial situation, performance, risk levels, and management effectiveness of a company can be determined by comparing these ratios over time and against industry standards.

In order to analyze a company's strengths and weaknesses, the financial ratio analysis helps investors to make important financial decisions. If you want to analyze a company, you will have to understand these trends thoroughly.

Application of Financial Ratio Analysis

Financial Ratio Analysis Over Time

The Financial ratio analysis over time is used by the company in order to understand the trends and progress. The company focuses on how it has progressed over time instead of just looking at the current state of the company. It analyzes the changes that proved to be successful and the remaining risks for the future.

To make long-term decisions and strategic plans company picks a specific financial ratio and calculates it every month regularly. You should keep in account the seasonal effects and temporary fluctuations in account balances. The company keeps an eye on how this ratio changes over time, how frequently it is changing, and checks if the changes are moving in the desired direction.

Financial Ratio Analysis Across Companies

Suppose a company has a gross profit margin of 10%. This range of gross profit would be satisfactory for that company until it learns about the other companies with a gross profit margin of 25%. Financial ratio analysis helps a company to compare its progress with its competitors.

You have to compare the companies from similar industries in order to get a clear picture. Do not forget the differences in company size, funding, and product types. These factors can have a huge impact on the efficiency and progress of a company and its ratios.

Financial Ratio Analysis Against Benchmarks

In order to maintain progress and stability, companies set goals for their financial ratios. You can get a clear picture with this example: suppose a company has set a financial ratio goal of 1:2, but its current financial ratio is 1:1. That company will work to achieve that goal and will be more financially stable by the end of the year.

Different benchmarks are set by lenders and external partners, which are a part of the agreement. If the company is not able to meet the benchmark, then the lender can increase the interest rate of the loan or ask the company to pay the loan back early.

Types of Financial Ratio

Liquidity Ratios

The liquidity ratio is used to determine the ability of a company to pay off short-term debts with the help of the company's current or quick assets. The current ratio, quick ratio, and working capital ratio are included in the liquidity ratio.

Solvency Ratios

Solvency ratios are also known as leverage ratios that compare the debt levels of the company with its assets, income and equity. This comparison is done to check if it can pay off its long-term debt and obligations.

Profitability Ratios

The profitability ratio is used to check the ability of a company to generate profit. Some examples of profitability ratios are gross margin ratios, Profit ratios, return on assets, return on equity, and return on capital

Efficiency Ratios

The purpose of the efficiency ratio is to evaluate the company's efficiency to generate sales and generate profits using its assets and liabilities.

Examples of Ratio Analysis

Example#1

Let's assume a company named XYZ and another company named ABC belong to a similar industry with a profit margin of 50% and 10%, respectively. In order to identify which company is generating better profit, the investor will compare both of these companies and conclude that ABC generated more profit.

Example#2

Let's assume a company named XYZ and another company named ABC belong to a similar industry with a P/E ratio of 100 and 10, respectively. The P/E ratio of a company tells how much an investor is willing to pay for each earning of a dollar. For the company XYZ, the investor is ready to pay $100 for $1 earnings. However, the investor is ready to pay $10 for $1 in earnings.

Conclusion

A huge amount of useful information is available so the company can make informed decisions. However, a company has to compare various numbers in order to use that information wisely. The process of financial analysis allows a company to dive deep into its performance over time against its competitors and internal goals. We hope we have covered all the information about what is financial ratio analysis.