Financial management: Ratio Analysis and Its Objectives

In this article , we are going through the ratios analysis which is important for any organization to assess their stability, liquidity, profitability and solvency and it is useful for the commerce and management students also.

Ratio Analysis

The term ratio analysis consists of two terms I.e. ratio and analysis. Ratio means numerical relationship between two accounting figures or values. Analysis means examination and interpretation. `therefore, ratio analysis means examination and interpretation of numerical relationship of two values. The relationship between two accounting figures can be expressed in different mathematical forms like percentage, number of times, ratio form etc. Ratio analysis is widely used tool of financial analysis. It enables the users to measure the performance of the business. It facilitates inter firm as well as intra firm comparison.

Keywords to Ratios

• Ratio analysis can mark how a company is performing over time, while comparing a company to another within the same industry or sector.
• While ratios offer useful insight into a company, they should be paired with other metrics, to obtain a broader picture of a company’s financial health.
• Ratio analysis compares line-item data from a company’s financial statements to reveal insights regarding profitability, liquidity, operational efficiency, and solvency.

Examples of Ratio Analysis Categories

The various kinds of financial ratios available may be broadly grouped into the following six silos, based on the sets of data they provide:

1. Liquidity Ratio

Liquidity ratios measure a company’s ability to pay off its short-term debts as they become due, using the company’s current or quick assets. Liquidity ratios include the current ratio, quick ratio, and working capital ratio.

2. Solvency Ratios

Also called financial leverage ratios, solvency ratios compare a company’s debt levels with its assets, equity, and earnings, to evaluate the likelihood of a company staying afloat over the long haul, by paying off its long-term debt as well as the interest on its debt. Examples of solvency ratios include: debt-equity ratios, debt-assets ratios, and interest coverage ratios.

3. Profitability Ratios

These ratios convey how well a company can generate profits from its operations. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios are all examples of profitability ratios.

4. Efficiency Ratios

Also called activity ratios, efficiency ratios evaluate how efficiently a company uses its assets and liabilities to generate sales and maximize profits. Key efficiency ratios include: turnover ratio, inventory turnover, and days’ sales in inventory.

5. Coverage Ratios

Coverage ratios measure a company’s ability to make the interest payments and other obligations associated with its debts. Examples include the time interest coverage ratio and the debt service coverage ratio.

6. Market Prospect Ratios

These are the most commonly used ratios in fundamental analysis. They include dividend yield, P/E ratio, earnings per share (EPS), and dividend payout ratio. Investors use these metrics to predict earnings and future performance.

Objectives of Ratio Analysis

1] Measure of Profitability

Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 9 lacs last year, how will you determine if that is a good or bad figure? Context is required to measure profitability, which is provided by ratio analysis. Gross profit ratios, net profit ratio, Expense ratio etc provide a measure of the profitability of a firm. The management can use such ratios to find out problem areas and improve upon them.so, operating ratio is to be calculated.

2] Evaluation of Operational Efficiency

Certain ratios highlight the degree of efficiency of a company in the management of its assets and other resources. It is important that assets and financial resources be allocated and used efficiently to avoid unnecessary expenses. Turnover ratios and Efficiency Ratios will point out any mismanagement of assets.

3] Ensure Suitable Liquidity

Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So the liquidity of firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm maintain the required level of short-term solvency.

4] Overall Financial Strength

There are some ratios that help determine the firm’s long-term solvency. They help determine if there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are debt equity ratios, Leverage ratios etc.

5] Comparison

The organizations’ ratios must be compared to the industry standards to get a better understanding of its financial health and fiscal position. The management can take corrective action if the standards of the market are not met by the company. The ratios can also be compared to the previous years’ ratio’s to see the progress of the company. This is known as trend analysis.

6) Budgeting , Planning and control

ratio analysis helps the management in its basic functions of budgeting , planning and control. and it helps to know the organization to know their weaknesses and strength.