Financial Ratio Analysis: Meaning, Types, Formulas, Importance & Limitations

Introduction to Financial Ratios

Ratio analysis is one of the oldest methods of financial statements analysis. It was developed by banks and other lenders to help them chose amongst competing companies asking for their credit. Two sets of financial statements can be difficult to compare. The effect of time, of being in different industries and having different styles of conducting business can make it almost impossible to come up with a conclusion as to which company is a better investment. Ratio analysis helps creditors solve these issues. Here is how:

What is Financial Ratio Analysis?

1. Shortcut: Financial ratios provide a sort of heuristic or thumb rule that investors can apply to understand the true financial position of a company. There are recommended values that specific ratios must fall within. Whereas in other cases, the values for comparison are derived from other companies or the same companies own previous records. However, instead of undertaking a complete tedious analysis, financial ratios help investors shortlist companies that meet their criteria.
2. Sneak-Peek: Investors have limited data to make their decisions with. They do not know what the state of affairs of the company truly is. The financial statements provide the window for them to look at the internal operations of the company. Financial ratios make financial analysis simpler. They also help investors compare the relationships between various income statement and balance sheet items, providing them with a sneak peek of what truly is happening behind the scenes in the company.
3. Connecting the Dots: Over the years investors have realized that financial ratios have incredible power in revealing the true state of affairs of a company. Analyses like the DuPont Analysis have brought to the forefront the inter-relationship between ratios and how they help a company become more profitable. 

Sources of Data for Ratio Analysis 

Here is where the investors get the data they require for ratio analysis:

1. Financial Statements: The financial data published by the company and its competitors is the prime source of information for ratio analysis.
2. Best Practices Reports: There are a wide range of consulting firms that collate and publish data about various companies. This data is used for operational benchmarking and can also be used for financial data analysis.
3. Market: The data generated by all the activity on the stock exchange is also important from ratio analysis point of view. There is a whole class of ratios where the stock price is compared with earnings, cash flow and such other metrics to check if it is fairly priced.

Types of Financial Ratio

1. LIQUIDITY & SOLVENCY RATIOS:

• Current Ratio: Current ratio is a ratio between current assets and liabilities, which tells that for every dollar in current liabilities, how many current assets do the company possess. Since the current liabilities are usually paid out of current assets, it makes sense to compare the two figures to assess the liquidity of the firm. Liquidity implies the ease with which the current liabilities can be paid off. Generally, the higher the ratio, the better it is considered, but too high a ratio may imply less productive use of current assets. A ratio of two to one (2:1) is considered ideal. = Current Assets / Current Liabilities
• Quick/Acid Test ratio: Quick ratio is relatively a stringent measure of liquidity. The ratio is obtained by subtracting inventory from current assets and dividing the result by current liabilities. Inventory is the least liquid of all current assets. By subtracting inventory from current assets, we are actually comparing more liquid assets with current liabilities. This ratio not only helps in gauging the solvency of the company, it may also show if the inventories are piling up. A desirable quick ratio can range from (0.8:1) to (1.5:1) depending on the nature of the business. = (Current Assets – Inventory) / Current Liabilities
• Average Collection Period: Also known as Days Sales Outstanding, average collection period shows in how many days the Accounts receivables of the company are converted into cash. Most of the companies sell most of their products/services on credit basis, hence it is critical for the company to know in how much time these receivables could be converted to cash in order to ensure liquidity at all Times Average collection period is calculated using the following formula = Average Accounts Receivable / (Annual Sales/360)

Note: Average collection period is usually expressed in terms of days. If you find a decimalized answer, you should round it off to the next integer.

2. PROFITABILITY RATIOS:

The profitability ratios show the combine effects of liquidity, asset management, and debt management on operating result.

• Profit Margin (on sales): One of the most commonly used ratios is profit margin on sales. This ratio tells the percentage of profit for every dollar of revenue earned. This ratio is usually expressed in terms of percentage and the general rule is, the higher the ratio, the better it is. Most of the companies compare this ratio to the previous years’ ratios to assess if the company is better off. = [Net Income / Sales] X 100
• Return on Assets: Return on assets is another profitability ratio, which shows the profitability of the company against each dollar invested in total assets. We can obtain this figure by simply by dividing the net profit with total assets. Since the assets are economic resources that are used to earn profit, it is logical to assess if the assets have been used efficiently enough to generate profits. This ratio is also expressed in percentage terms. = [Net Income / Total Assets] X 100
• Return on equity: Return on equity is of special interest to the shareholders, since equity represents the owners’ share in the business. Return on equity can be obtained by dividing the net income with the total equity. This ratio shows that for each dollar in equity how much profit is generated by the company. = [Net Income/Common Equity]

3. ASSET MANAGEMENT RATIOS

These measures show how effectively the firm has been managing its assets.

• Inventory Turnover: Inventory turnover shows the number of times the inventories are replenished within one accounting cycle. The ratio can be obtained by dividing the sales by inventory. While the quick ratio measures the liquidity and points out the inventory piling problem, the inventory turnover confirms whether or not the major portion of the current assets of the firm are tied up in inventory. This ratio is also used in measuring the operating cycle and cash cycle of the firm. A higher turnover is desirable as it reflects the liquidity of the inventories. = Sales / inventories
• Total Assets Turnover: An effective use of total assets held by a company ensures greater revenue to the firm. In order to measure how effectively a company has used its total assets to generate revenues, we compute the total assets turnover ratios, dividing the sales by total assets. = Sales / Total Assets An increasing ratio over the years may show that with an addition of assets, the company has been able to generate incremental sales in greater proportion.

4. DEBT (OR CAPITAL STRUCTURE) RATIOS:

• Debt-Assets: A commonly used ratio to measure the capital structure of the firm is debt to assets ratio. Capital structure refers to the financing mix (proportion of debt and equity) of a firm. The greater the proportion of debt in the financing mix, the less willing creditors, and investors would be to provide more finances to the company. In India, the debt to assets ratio is prescribed in prudential regulations by the State Bank of India as a guideline for the banks (creditors). A ratio greater than 0.66 to 1 is considered alarming for the providers of funds. = Total Debt / Total Assets
• Debt-Equity: Another commonly used ratio, debt to equity, explicitly shows the proportion to debt to equity. A ratio of 60 to 40 is used for new projects, i.e., for a project it is permitted to raise its finances 60 percent from the debt and 40 percent from equity. Debt to equity is computed by the following formula. = Total Debt / Total Equity
• Times-Interest-Earned: Times-interest-earned reflects the ability of a company to pay its financial charges (interest). This ratio is obtained by dividing the operating profit by the interest charges. Conceptually, the interest charges are to be paid from the earnings before interest and taxes. A ratio of 4 to 1 show that the company covers the interest charges 4 times, which is generally considered satisfactory by the management, however, a ratio higher than that, may be more desirable. A high time interest- earned ratio is a good sign, especially for the creditors. = EBIT / Interest Charges
• Market Value Ratios: Market value ratios relate the firm’s stock price to its earnings & book value per share. These ratios give management an indication of what equity investors think of the company’s past performance & future prospects
• Price Earnings Ratio: It shows how much investors are willing to pay per rupee of reported profits. This ratio reflects the optimism, or lack thereof, investors have about the future performance of the company. = Market Price per share / *Earnings per share
• Market /Book Ratio: Market to book ratio gives an indication how equity investors regard the company’s value. This ratio is also used in case of mergers, acquisition or in the event of bankruptcy of the firm. = Market Price per share / Book Value per share
• Earnings Per Share (EPS) = Net Income / Average Number of Common Shares Outstanding

Limitations of Ratio Analysis 

Ratio analysis, without a doubt, is amongst the most powerful tools of financial analysis. Any investor, who wants to be more efficient at their job, must devote more time towards understanding ratios and ratio analysis. However, this does not mean that it is free of limitations. Like all techniques, financial ratios have their limitations too. Understanding the limitations will help investors understand the possible shortcomings with ratios and avoid them. Here are the shortcomings:

1. Misleading Financial Statements - The first and foremost threat to ratio analysis is deliberate misleading statements issued by the management. The management of most companies is aware that investors look at certain numbers like sales, earnings, cash flow etc very seriously. Other numbers on the financial statements do not get such attention. They therefore manipulate the numbers within the legal framework to make important metrics look good. This is a common practice amongst publicly listed companies and is called “Window Dressing”. Investors need to be aware of such window dressing and must be careful in calculating and interpreting ratios based on these numbers.
2. Incomparability - Comparison is the crux of ratio analysis. Once ratios have been calculated, they need to be compared with other companies or over time. However, many times companies have accounting policies that do not match with each other. This makes it impossible to have any meaningful ratio analysis. Regulators all over the world are striving to make financial statements standardized. However, in many cases, companies can still choose accounting policies which will make their statements incomparable.
3. Qualitative Factors - Comparison over time is another important technique used in ratio analysis. It is called horizontal analysis. However, many times comparison over time is meaningless because of inflation. Two companies may be using the same machine with the same efficiency but one will have a better ratio because it bought the machine earlier at a low price. Also, since the machine was purchased earlier, it may be closer to impairment. But the ratio does not reflect this.
4. Subjective Interpretation - Financial ratios are established “thumb of rules” about the way a business should operate. However, some of these rules of thumb have become obsolete. Therefore, when companies come with a new kind of business model, ratios show that the company is not a good investment. In reality the company is just “unconventional”. Many may even call these companies innovative. Ratio analysis of such companies does not provide meaningful information. Investors must look further to make their decisions.

Conclusion

Financial ratio analysis is an essential tool for evaluating the financial performance, profitability, liquidity, efficiency, and solvency of a business. It helps investors, creditors, managers, and students understand the true financial position of a company through meaningful comparisons and calculations. Different types of ratios such as liquidity ratios, profitability ratios, asset management ratios, debt ratios, and market value ratios provide valuable insights for decision-making. Although ratio analysis has certain limitations like misleading financial statements and subjective interpretation, it remains one of the most effective techniques of financial analysis when used carefully. Overall, financial ratios simplify complex financial data and support better business and investment decisions.