It is a quantitative tool that uses ratios derived from a company’s financial statements (like balance sheet and income statement) to evaluate its performance, efficiency, liquidity, profitability, and solvency health of a company.
Key objectives of Ratio Analysis:
- Assess Financial Health: It provides a comprehensive view of financial position allowing the stakeholders to determine its overall stability.
- Evaluate Profitability: Profitability ratios such as Net profit Margin, Gross profit margin, Return on assets, and Return on equity assess how well a company generates profit relative to its revenue, assets, or equity.
- Analyze Liquidity: Liquidity ratio such as Current ratio and Quick ratio helps determine if a company can meet short-term obligations. These ratios are particularly important for
- Assess Solvency & Leverag: Solvency and leverage ratios evaluate a company’s ability to meet long-term obligations and its reliance on debt financing. Key ratios include debt to equity ratio and interest coverage ratio.
- Measure Operational Efficiency: Ratios such as Inventory Turnover and Asset Turnover evaluates how a company utilises its assets and manages expenses to generate revenue.
- Compare Performance: Serves as an essential tool for comparing a company’s financial performance across different periods.
- Support Decision-Making: By providing a data-driven foundation, financial ratios help organizations make strategic decisions that align with their growth objectives.
Types of Financial Ratios
- Profitability Ratios:
Profitability ratios are key financial metrics used to evaluate a company’s ability to generate profit relative to its revenue, assets, equity, or capital employed. These ratios help investors, business owners, and analysts assess the financial health and performance of a business. A higher profitability ratio generally indicates better efficiency and financial success, whereas a lower ratio may signal inefficiencies or financial challenges.
| S.no | Financial Ratios | Formula | Interpretation |
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Return on Equity | Net IncomeTotal Shareholder’s Equity 100 | Shows the return made by the company for ordinary shareholders. The higher the percentage, the better the overall profitability |
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Return on Capital Employed | EBIT Capital Employed 100 | Measures how efficiently a company uses its capital to generate profits, with a higher ROCE indicating better capital utilization and profitability. |
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Return on Total Assets | EBITAverage Total Assets 100 | Measures how effectively a company uses its assets to generate earnings, a higher ratio indicating better financial performance. |
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Net Profit Margin (%) | Net IncomeRevenue 100 | Measures the percentage of revenue remaining after deducting all expenses, Higher the Profit Margin, the better. |
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Gross Profit Margin (%) | Gross profitRevenue 100 | Indicates how efficiently a company manages its production costs, and a higher gross margin suggests better cost control and pricing power. |
- Operational Ratios:
Operational ratios are financial metrics that measure a company’s efficiency in utilizing resources to generate revenue and manage expenses. These ratios help businesses assess operational performance, cost control, and overall productivity. Higher efficiency in operations generally leads to improved profitability and sustainability.
| S.no | Financial Ratios | Formula | Interpretation |
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Net Assets Turnover | Net SalesAverage Total Assets | Measures how efficiently a company uses its assets to generate revenue; a higher ratio generally indicates better asset utilization and lower ratio indicates inefficient asset management. |
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Fixed Assets Turnover | Net SalesAverage Total Fixed Assets | Indicates how efficiently a company uses its fixed assets (like property, plant, and equipment) to generate sales, with a higher ratio generally signifying better asset utilization and efficiency. |
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Interest Cover | EBITInterest Expense | Measures a company’s ability to cover its interest payments with its operating income, with a higher ratio generally indicating better financial health. |
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Stock Turnover | COGSAverage Inventory | It measures how efficiently a company manages its inventory by showing how often it sells and replaces its stock over a period. A higher ratio indicates efficient inventory management and strong sales, while a lower ratio may suggest overstocking or slow sales. |
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Debtors Collection days | Net SalesAverage Debtors | Measures the average time it takes a business to collect payments from customers after a credit sale. Less no of days is better as it indicates that the company is collecting payments efficiently, leading to a stronger cash flow. |
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Creditors Payment days | Net Credit PurchaseAverage Creditors | This measures the average time a company takes to pay its suppliers. A higher ratio indicates the company takes longer to pay its suppliers, potentially allowing it to retain cash longer. So low is better as it suggests the company pays suppliers quickly. |
- Liquidity Ratios:
Liquidity ratios are financial metrics that measure a company’s ability to meet its short-term obligations using its current assets. These ratios help investors, creditors, and management assess a company’s financial health and ability to handle short-term financial challenges. A higher liquidity ratio indicates a stronger ability to pay off liabilities, while a lower ratio may signal financial stress.
| S.no | Financial Ratios | Formula | Interpretation |
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Current Ratio | Current AssetsCurrent Liabilities | Assesses a company’s ability to pay off its short-term liabilities (those due within one year) using its current assets (assets expected to be converted to cash within one year). |
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Quick Ratio | Current Assets – InventoryCurrent Liabilities | Also known as the acid-test ratio, measures a company’s ability to meet its short-term obligations using its most liquid assets (cash, marketable securities, and accounts receivable). A ratio above 1 generally indicates a healthy financial position, while a ratio below 1 suggests potential liquidity challenges. |
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Gearing Ratio | Total DebtTotal Equity | Also known as a leverage ratio, measures a company’s financial leverage by comparing its debt to its equity, indicating the proportion of business funded by debt versus equity. A higher ratio suggests more reliance on debt, potentially increasing financial risk, while a lower ratio suggests a more stable, equity-reliant structure. |
- Per Employee Ratios:
Per employee ratios are financial and productivity metrics that measure a company’s efficiency in utilizing its workforce. These ratios help businesses evaluate employee performance, labor cost efficiency, and overall organizational productivity. They are especially useful for industries where human capital plays a critical role, such as IT, manufacturing, and services.
| S.no | Financial Ratios | Formula | Interpretation |
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Profit Per Employee Ratio | Net IncomeNumber of employees | Measures the amount of profit a company generates for each employee, indicating workforce efficiency and productivity. A higher ratio generally suggests better financial performance and efficient workforce management. |
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Turnover Per Employee Ratio | Number of employees leftAverage Number of employees | Indicates how much revenue each employee generates, offering insights into efficiency, productivity, and profitability. A higher RPE suggests a more efficient and productive company. |
