Top 5 Types of Ratio Analysis
Ratio Analysis is done to analyze the Company’s financial and trend of the company’s results over a period of years where there are mainly five broad categories of ratios like liquidity ratios, solvency ratios, profitability ratios, efficiency ratio, coverage ratio which indicates the company’s performance and various examples of these ratios include current ratio, return on equity, debt-equity ratio, dividend payout ratio, and the price-earnings ratio.
The numerator and denominator of the ratio to be calculated are taken from the financial statements, thereby expressing a relationship with each other.
It is a fundamental tool that is used by every company to ascertain the financial liquidity, the debt burden, and the profitability of the company and how well it is placed in the market as compared to the peers.
Top 5 Types of Ratio Analysis
There are different types of ratios analysisRatios AnalysisRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements. that have been calculated by every company to evaluate business performance. Simply we may divide it as below:
Type #1 – Profitability RatiosProfitability RatiosProfitability ratios help in evaluating the ability of a company to generate income against the expenses. These ratios represent the financial viability of the company in various terms.
This type of ratio analysis suggests the Returns that are generated from the Business with the Capital Invested.
Gross Profit Ratio
It represents the operating profit of the company after adjusting the cost of the goods that are sold. The higher the gross profit ratio, the lower the cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. , and the greater satisfaction for the management.
Net Profit Ratio
It represents the overall profitability of the company after deducting all the cash & no cash expenses: the higher the net profit ratio, the higher the net worthNet WorthThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus., and the stronger the balance sheet.
Operating Profit Ratio
It represents the soundness of the company and the ability to pay off its debt obligations.
Return on Capital Employed
ROCEROCEReturn on Capital Employed (ROCE) is a metric that analyses how effectively a company uses its capital and, as a result, indicates long-term profitability. ROCE=EBIT/Capital Employed. represents the profitability of the company with the capital invested in the business.
Type #2 – Solvency Ratios
These ratio analysis types suggest whether the company is solvent & is able to pay off the debts of the lenders or not.
This ratio represents the leverage of the company. A low d/e ratio means that the company has a lesser amount of debt on its books and is more equity diluted. A 2:1 is an ideal debt-equity ratio to be maintained by any company.
Where, total debt = long term + short term + other fixed payments shareholder funds = equity share capital + reserves + preference share capital – fictitious assets.
Interest Coverage Ratio
It represents how many times the company’s profits are capable of covering its interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.. It also signifies the solvency of the company in the near future since the higher the ratio more comfort to the shareholders & lenders regarding servicing of the debt obligations and smooth functioning of the business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation. of the company.
Type #3 – Liquidity Ratios
These ratios represent whether the company has enough liquidity to meet its short term obligations or not. Higher liquidity ratios more cash-rich the company.
It represents the liquidity of the company in order to meet its obligations in the next 12 months. Higher the current ratio,Current Ratio,The current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities the stronger the company to pay its current liabilities. However, a very high current ratio signifies that a lot of money is stuck in receivables that might not realize in the future.
Formula = Current Assets / Current Liablities
It represents how cash-rich is the company to pay off its immediate liabilities in the short term.
Type #4 – Turnover Ratios
Theses ratios signify how efficiently the assets and liabilities of the company are used to generate revenue.
Fixed Assets Turnover Ratio
Fixed asset turnoverFixed Asset TurnoverThe fixed asset turnover ratio formula determines the ability of a business entity to generate revenue by employing its fixed assets. It is computed as the fraction of net sales and average net fixed assets. represents the efficiency of the company to generate revenue from its assets. In simple terms, it is a return on the investment in fixed assets. Net SalesNet SalesNet sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company's gross sales. = Gross Sales – Returns. Net Fixed Assets = Gross Fixed Assets –Accumulated Depreciation.
Average Net Fixed Assets = (Opening Balance of Net Fixed Assets + Closing Balance of Net Fixed Assets)/2.
Inventory Turnover Ratio
The Inventory Turnover RatioInventory Turnover RatioInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings. represents how fast the company is able to convert its inventory into sales. It is calculated in days signifying the time required to sell the stock on an average. The average inventory is considered in this formula since the inventory of the company keeps on fluctuating throughout the year.
Receivable Turnover Ratio
Receivables Turnover Ratio reflects the efficiency of the company to collect its receivables. It signifies how many times the receivables are converted to cash. A higher receivable turnover ratio also indicates that the company is collecting money in cash.
#5 – Earning Ratios
This ratio analysis type speaks about the returns that the company generates for its shareholders or investors.
PE RatioPE RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. represents the earnings multiple of the company, the market value of the shares based on the pe multiple. A high P/E Ratio is a positive sign for the company since it gets a high valuation in the market for m&a opportunity.
Earnings Per Share
Earnings Per ShareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. represents the monetary value of the earnings of each shareholder. It is one of the major components looked at by the analyst while investing in equity marketsEquity MarketsAn equity market is a platform that enables the companies to issue their securities to the investors; it also facilitates the further exchange of these stocks between the buyers and sellers. It comprises various stock exchanges like New York Stock Exchange (NYSE)..
Return on Net Worth
It represents how much profit the company generated with the invested capitalInvested CapitalInvested Capital is the total money that a firm raises by issuing debt to bond holders and securities to equity shareholders. Invested Capital Formula = Total Debt (Including Capital lease) + Total Equity & Equivalent Equity Investments + Non-Operating Cash from equity & preference shareholders both.
The above mentioned are some of the ratios analysis types that can be used by the company for its financial analysisFinancial AnalysisFinancial analysis is an analysis of finance-related projects/activities, company's financial statements (balance sheet, income statement, and notes to accounts) or financial ratios to evaluate the company's results, performance, and trends, which is useful for making significant decisions such as investment, project planning and financing activities.. In this way, ratio analysis is a very important tool for any kind of strategic business planning by the top management of the company.
This article has been a guide to Ratio Analysis Types. Here we discuss the top 5 types of ratio analysis, including profitability ratios, solvency ratios, liquidity ratios, turnover ratios, and earnings ratios, etc. You can learn more about financing from the following articles –