What Are Ratio Analysis Types?
Ratio Analysis Types refer to different forms of ratio analyses that are conducted to figure out the exact status or progress of a business. The ratio analysis forms help analyze the company’s financial and trend of the company’s results over years. It is a fundamental tool that every company uses to ascertain the financial liquidity, debt burden, profitability, and how well it is placed in the market compared to its peers.
Some of the categories of ratio analysis include liquidity ratios, solvency ratios, profitability ratios, efficiency ratio, and coverage ratio which indicates the company’s performance. Various examples of these ratios include the current ratio, return on equity, debt-equity ratio, dividend payout ratio, and price-earnings ratio. These different types of ratio analysis make financial analysis easier to conduct for companies, thereby helping them plan their progress accordingly.
Table of contents
- . Ratio analysis is a helpful tool for assessing a company’s financial health and progress over time. It involves analyzing five categories of ratios, including liquidity, solvency, profitability, efficiency, and coverage. These ratios can give you valuable insights into the company’s performance.
- Profitability ratios, solvency ratios, liquidity ratios, turnover ratios, and earning ratios are five types of ratio analysis.
- Financial analysis in companies can benefit from various types of ratio analysis. Top management can use it as a crucial tool for strategic business planning.
Ratio Analysis Types Explained
Ratio analysis types exist in several form and based on the figures and assessment data that firms need to generate to understand its progress or decline, the analysts choose a specific type of it for further calculation and quantitative derivations. This is because not all ratio analysis type suits all kinds of requirements of a business. Hence, the ratio to be calculated for analysis must be chosen based on the kind of data required for it.
Though there are five widely used types of ratio analysis, choosing a random type may not help firms assess their current position in the market. For example, if a business desires to check its debt-to-equity ratio, it has to compute this particular ration for valid figures. Finding out gross profit ratio in such a scenario would not help organizations.
Therefore, it is important to choose the appropriate ratio analysis type for a more accurate and reliable overview of the business performance. So far as being correct in deriving a proper conclusion is concerned, multiple ratio analysis should be conducted for better support to the figures obtained. If more ratio analysis suggests growth, that means the business is on the right track. The numerator and denominator of the ratio to be calculated are taken from the financial statements, thereby expressing a relationship with each other. This is done based on the type of ratio selected for analysis. For example, if a business wants to learn about the returns expected on the capital employed, the numerator will be Earnings Before Interests and Taxes (EBIT) and the denominator will be the capital employed. On the other hand, if the ratio to be obtained is the return on net worth, the numerator and denominator would be different, i.e., net profit and equity shareholder’s funds, respectively.
The above mentioned are some ratios analysis types that the company can use for itsFinancial 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. 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 company’s top management.
Top 5 Types of Ratio Analysis
Every company has calculated 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. to evaluate business performance. The details of each one of them have been mentioned below for better clarity of ratio analysis types as a concept as well as its calculation:
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 generated from the Business with the Capital Invested.
Gross Profit Ratio
It represents the company’s operating profit 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.
Financial Modeling & Valuation Course (25+ Hours of Video Tutorials)
Net Profit Ratio
It represents the company’s overall profitability after deducting all the cash & no cash expenses: the higher the net profit ratio, the higher the The 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.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 company’s profitability with the capital invested in the business.
Type #2 – Solvency Ratios
These ratio analysis types suggest whether the company is solvent & can pay off the lenders’ debts 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 can cover 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 company’s solvency shortly since the higher the ratio, the 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 are more cash-rich for the company.
It represents the company’s liquidity 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 be realized in the future.
Formula = Current Assets / Current Liablities
It represents how cash-rich the company is to pay off its immediate liabilities in the short term.
Type #4 – Turnover Ratios
These 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 can 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 company’s inventory 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 company’s returns 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 company’s earnings multiple and 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 opportunities.
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 valueMonetary ValueMonetary value refers to the value of a product or service measured in terms of money. 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 shareholdersPreference ShareholdersA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation. both.
Frequently Asked Questions (FAQs)
There are three types of ratio analysis. The first is the current ratio, which measures a company’s ability to pay short-term liabilities with existing assets. The second is the quick ratio, the acid test ratio, which measures the ability to pay short-term liabilities with quick assets. The third is the cash ratio.
Examining every detail of a company’s financial statements, ratio analysis helps assess its overall economic well-being. It lets you determine whether a company’s financial health has improved or declined. Furthermore, you can compare a company’s financials to its peers or the industry through ratio analysis.
External analysts primarily perform ratio analysis using financial statements as their primary source of information. These analysts obtain essential data to assess a company’s economic performance by analyzing current and past financial statements.
This article has been a guide to what are Ratio Analysis Types. We explain the top 5 types of it – Profitability, Solvency, Liquidity, Turnover & Earnings Ratios. You can learn more about financing from the following articles –