Financial Ratio Analysis is a popular method of analysing a company’s financial statements. These ratios help decipher results and compare them to previous years and other companies in the same industry. Financial ratios are divided into several categories, some of which are:
Liquidity Ratio
Coverage Ratio
Leverage Ratio
Profitability Ratio
Let us read more about them.
What are the different types of financial ratio?
Listed below are some of the commonly used financial ratios.
1. Liquidity Ratio Analysis:
This ratio is used to understand the ability of a company to meet its current debt obligation by using its current asset holdings. There are two broad categories of Liquidity Ratios:
Current Ratio – It measures the company’s ability to cover its short-term obligations with its current assets.
Formula:
Many analysts exclude inventory from this calculation as it takes time to sell and liquidate it. Instead, they use the Quick ratio.Quick Ratio – This ratio emphasises assets that can be converted to cash quickly. A higher ratio indicates better performance of the business.
Formula:Analysts prefer current ratios that are greater than 2:1 and quick ratios that are less than 1:1. This means investors prefer investing in a business that has higher existing assets than liabilities.
2. Coverage Ratio Analysis:
This analysis method is used to evaluate the ability of a company to pay its interest, fees, and charges due on its debt. Common coverage ratios are:
Interest Coverage Ratio – It indicates the company’s ability to pay only the interest expense on the debt.
Formula:Debt Service Coverage Ratio – It shows the company’s capacity to repay the principal and interest along with all its debt obligations.
Formula:
3. Leverage Ratio Analysis:
This measure helps to get a better picture of a company’s debt levels. Two common leverage ratios include:
Total Debt Ratio – This ratio measures the percentage of a company's assets that are provided via debt.
Formula:Debt-to-Equity Ratio – This measure tells you how much debt the company uses to run the business.
Formula:
4. Profitability Ratio Analysis
This measure shows the company’s capacity to make a profit. It indicates how much of the profit is left after deducting all costs and expenses. The common profitability ratios are:
Gross Margin Ratio – This ratio compares the gross profit of a company to its net sales. It shows the amount of profit a company makes after paying its cost of goods sold.
Formula:
Operating Margin Ratio – This ratio compares the operating income of a company to its net sales. It helps to determine the operational efficiency of a company.
Formula:Return on Assets Ratio – This ratio shows how efficiently a company is using its assets to generate profit.
Formula:
Return on Equity Ratio – This ratio measures how efficiently a company uses its equity to generate profit.
Formula:
How is Financial Ratio Analysis helpful?
Each financial ratio reveals the financial health of a company and helps to track its performance. The gathered data also helps you to identify developing trends in the company. For instance, if a company’s debt-to-asset ratio decreases, it reflects the company's financial stability. Hence, it is essential that the company makes sound investment and purchase decisions.
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