The financial statement used for obtaining swift integration of an entity’s performance in key areas is known as ratio analysis. The ratio analysis aims to compare relationships between financial statement accounts that enables managers or investors to determine the health of business. It provides us with crucial financial information and points out the areas that require investigation.
Ratio analysis is a technique that involves regrouping of data by the application of arithmetical relationships; its interpretation is a complex matter. Ratio analysis requires a good understanding of the techniques and ways used for making financial statements. Once it is done effectively, it provides a lot of financial information that helps the analyst.
Financial Ratios for Business
A quick ratio shows that a firm can meet its financial obligations and pay off its liabilities even in the case of an unanticipated situation. This ratio indicates the extent to which a company has quick assets to pay off its current liabilities. Higher the ratio, Higher the solvency level of the company and less the risk of being bankrupt.
Quick Ratio = (Current Assets, Loans & Advances – Current Inventory- Prepaid Expenses) / Current Liabilities & Provisions – Bank Overdrafts
Current ratio shows a company’s present financial strength. It is similar to the Quick Ratio, and this is also used to determine the short-term solvency of a company. A good current ratio indicates a strong short-term solvency position of the company. This is also sometimes referred to as working capital ratio.
Current Ratio = (Total Current Assets, Loans & Advances) / Total Current Liabilities & Liabilities
Inventory turnover ratio
Inventory turnover ratio shows how frequently a company converts inventory into sales. This ratio reveals the inventory holding period. The shorter the holding period, Faster is the conversion of inventory into sales indicating better efficiency.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories
ROI (Return on Investment)
ROI basically compares the amount you invest in your business to how much money you make from that investment. This ratio measures the profitability of your business. Higher the ROI Ratio, higher the profit your business will make. Investors also check this ratio as a primary indicator before investing money in any business.
ROI = (Earnings – Initial Cost of Investment) / Initial Cost of Investment
Return on Capital Employed (ROCE)
This ratio indicates the return by the company on its total on investment. It is the ultimate measure of the company’s overall performance and productivity of capital employed, this ratio when compared with industry average gives an indication about the financial performance of the company. ROCE is a very useful ratio in analysing capital-intensive companies in telecom / oil and gas / heavy industries etc.
ROCE = Profit before interest and taxes / Total Capital employed
Return on Equity (ROE)
This ratio indicates the income earned by equity shareholders. High ratio means high dividend, better prospects and high valuation in the capital market.
Equity shareholder Funds = Equity Share Capital + Reserves and Surplus +/- Deferred Tax Assets or Liabilities
ROE = (Profit after tax- Preference dividend / Total capital employed) * 100
Earnings per Share (EPS)
This ratio shows the earnings made on each share of a company. It is one the important measures of profitability for the analysts or investors. This ratio is the main consideration for valuation of companies in case of mergers, etc. Higher ratio shows that the company is in a positive light. Higher ratio indicates higher returns.
Earnings per share (EPS) measures the net income earned on each share of a company’s stock.
EPS = Profit after tax- Preference dividend / Number of equity shares
Debt-Equity Ratio (DER)
This ratio indicates whether the company is relying on its own funds or borrowed funds. The debt-equity ratio shows a firm’s total long-term debt as a percentage of its owner’s total equity.
Higher the debt, more fixed liabilities by way of interest and more financial risk for the company. This ratio also indicates whether the company has an optimal capital structure to improve the returns available to equity shareholders.
Debt equity ratio = Long-term debt / Equity
Debtor Turnover Ratio
This ratio shows the efficiency with which debtors are converted into cash. The higher the ratio, the greater the speed with which debtors are converted into cash. This ratio can also be expressed in terms of the number of days.
Debtor Turnover Ratio = Net Sales/Average Debtors
This ratio is to the working capital ratio but while calculating this ratio only cash and cash equivalents are taken into consideration. Cash equivalent refers to the total value of cash in hand that includes items that are similar to cash or investments which mature within 90 days. Treasury bills, Treasury notes, Commercial paper are some examples of cash equivalents.
Cash ratio = Cash and cash equivalents/Current liabilities