Types of Ratio Analysis
Ratio Analysis is a mathematical tool used to evaluate the financial position of a company and compare the outcome with the previous year figures and also analyze the performance of the company as compared to its peers. There are primarily 5 types of ratio analysis – profitability ratios, solvency ratios, liquidity ratios, turnover ratios and earning ratios.
- 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 been placed in the market as compared to the peers.
Top 5 Types of Ratio Analysis
There are different types of ratios analysis that have been calculated by every company to evaluate business performance. Simply we may divide it as below:
Type #1 – Profitability Ratios
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 been sold. Higher the gross profit ratio, lower the cost of goods sold and greater satisfaction for the management.
Net Profit Ratio
It represents the overall profitability of the company after deducting all the cash & no cash expenses. Higher the net profit ratio, higher the net worth and 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
ROCE 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.
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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 expense. It also signifies the solvency of the company in the near future since higher the ratio more comfort to the shareholders & lenders regarding servicing of the debt obligations and smooth functioning of the business operations 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, stronger the company to pay its current liabilities. However, a very high current ratio signifies that a lot of money is been stuck in receivables that might not realize in the future.
It represents how cash rich is the company to pay off its immediate liabilities in the short term.
Type #4 – Turnover Ratios
Theses ratios signifies how efficiently the assets and liabilities of the company are been used to generate revenue.
Fixed Assets Turnover Ratio
Fixed asset turnover 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 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
Inventory Turnover Ratio 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. Average inventory is been 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 been converted to cash. A higher receivable turnover the 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 Ratio 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 Share 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 markets.
Return on Net Worth
It represents how much profit the company generated with the invested capital 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 analysis. 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 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 –