What is Ratio Analysis? Types, Importance, Limitations

  • Post last modified:21 April 2021
  • Reading time:24 mins read
  • Post category:Finance
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What is Ratio Analysis?

Ratio analysis refers to the study of various financial ratios to evaluate the performance of the firm. The utility of ratio analysis lies in the fact that a single financial figure in itself does not hold much meaning by itself but when expressed in terms of other figures, it provides significant information for decision making purpose.

For example, let’s say that net profit in year 1 was Rs.20 crore while in year 2 was Rs.30 crore. Looking at these numbers, one would tend to believe that the performance in year 2 was better than year 1.

Let’s say that the sale in year 1 was Rs.50 crore while it was Rs.100 crore in year 2. Now, if we calculate the profit margin, we find that the margin was 40% in year 1 while it was just 30% in year 2.

So, on the basis of profit margin, we find that year 1 was better than year 2 which is opposite to what we obtained when we compared just net profit numbers. Thus, ratio analysis helps in making an informed judgment about the performance of the company.

A ratio refers to an arithmetical relationship between two variables. Thus financial ratios are nothing but arithmetical relationship between two or more items in a financial statement.

Types of Ratio Analysis

Four Types of Ratio Analysis are:

  1. Liquidity ratios
  2. Leverage ratios
  3. Profitability ratios
  4. Activity ratios

Liquidity Ratios

The importance of liquidity lies in the fact that it helps in evaluating the ability of the firm to meet its short term obligations. Liquidity ratios measure the short term solvency of the firm.

The important liquidity ratios are:

  • Current ratio
  • Quick ratio
  • Super quick ratio

Current Ratio

It is the ratio of current assets and current liabilities. It is represented as:

Current Ratio = Current Assets / Current Liabilities

Current Assets are those which can be converted into cash in a time period not exceeding one year. They include cash, bank balance, inventory (raw material, work in progress & finished goods), prepaid expenses, bills receivable & debtors.

Current liabilities represent those liabilities which have to be paid in the next one year and include bills payable, bank loan, dividend payable, outstanding expenses, creditors and provision for taxation.

Although there are no hard and fast rules, an ideal current ratio should be 2:1. This implies that current assets should be twice the current liabilities. The higher the current ratio of the firm, the better is its short term solvency.

When comparing two firms, the firm having higher current ratio is considered to be better than the other in meeting its short term liquidity requirements.

However, it is important to be cautious while interpreting the current ratio as not only its value, but also the composition of current assets or liabilities is to be carefully observed.

For instance, a firm having a higher proportion of its current assets in the form of cash and bank balances would be in a better position than the firm with a higher proportion in inventory and debtors even though their current ratios might be the same.

Quick Ratio

It is the ratio of quick assets and current liabilities.

Quick Ratio= Quick Assets / Current Liabilities = Current Assets – Inventory – prepaid Expenses / Current Liabilities

Quick assets are those assets which can be converted into cash in a very short period of time without loss of value. These include:

  • Short term marketable securities
  • Cash and Bank balances
  • Debtors/receivables

Quick ratio is a stringent measure of the liquidity position of the company. A ratio of 1:1 is considered to be satisfactory.

Super quick ratio

It is the ratio of super-quick assets and current liabilities.

Quick Ratio = Super Quick Assets / Current Liabilities = Cash Balance+Bank Balance+Marketable securities / Current Liabilities

Out of the three solvency ratios, super-quick or cash ratio is considered to be the most rigorous is measuring the short term solvency position of the company. This ratio is essentially used as a conservation test and is not widely used in practice.

Leverage Ratios

Financial leverage refers to usage of debt to finance business activities. These ratios are used to assess the long term solvency as they measure the ability of the firm to service the interest payments regularly and pay back the principal on due date.

The following are the important types of leverage ratios:

  • debt-equity ratio
  • debt-assets ratio
  • interest coverage ratio
  • fixed charges coverage ratio
  • debt service coverage ratio

Debt-Equity ratio

This ratio shows the relative proportion of borrowed funds and shareholders capital in the capital structure of the firm. Alternatively, this ratio indicates the contribution of debt and equity in financing the assets of the firm. The term “borrowed funds” generally refers to long term debt of the company.

Debt-Equity Ratio = Long- term debt / Shareholder’s Equity

Sometimes, a different approach to calculate debt-equity ratio is employed where instead of only long-term debt, total debt (i.e. both short term and long term debt) is used. That is

This ratio indicates the margin of safety for the creditors. If the debt to equity ratio is high, it means that the owners are putting up less of their capital as compared to their creditors.

This in case of any project failures, the creditors will lose more money than the owners. Also, a high D/E ratio may lead the owners to behave recklessly while planning and implementing projects as they have fewer stake involved.

Debt-assets ratio

This ratio denotes the proportion of total assets which have been financed by borrowed funds.

Debt-assets Ratio = Total debt / Total assets

Total debt includes both short term as well as long term debt.

Interest Coverage ratio

This ratio measures the interest servicing capacity of the firm in so far as interest on long term debt is concerned.

Interest coverage Ratio = PBIT / Interest

PBIT denotes Profit before Interest and Tax. Profit before tax is used in the calculation because interest payments are not affected by tax considerations.

In fact, interest is a tax-deductible expense and the tax is calculated only after deducting the interest payments. A high interest coverage ratio indicates that the firm will be able to meet its interest obligations even after substantial decline in its profits.

For example, if the value of the interest coverage ratio is 5, it means that even if the PBIT declines by 5 times, then also the firm will be able to meet its interest obligations. It is used by lenders to evaluate the debt capacity of the firm. It is also an important determinant of bond rating.

Fixed charges coverage ratio

This ratio looks at the ability of the firm to meet all its fixed obligations.

These obligations may include

  • preference dividend
  • lease payments
  • interest on loan
  • repayment of principal

Fixed charges coverage Ratio = PBIT+Lease payments / Interest+Lease payments + Preference dividend + loan instalment / (1-tax rate)

This ratio is a more comprehensive measure of the debt repaying capacity of the firm as it includes both interest as well as principal repayment.

Debt service coverage ratio

It is widely used by financial institutions to evaluate the ability of the firm to meet all its debt service obligations. It can be defined as:

DSCR = Profit after Tax + Depreciation + Interest + Other non-cash expenses / Interest + Repayment of Principal

Profitability Ratios

These ratios help in measuring the efficiency with which the operations of the firm are carried out. Profitability ratios help in calculating the profitability of an organisation.

Some of the important profitability ratios are:

  • Gross Profit ratio
  • Net Profit ratio
  • Return on Investment
  • Earnings Per Share (EPS)
  • Price-earnings ratio

Gross Profit Ratio

Also known as gross margin, this ratio describes the relationship between gross profit and sales. It can be calculated as:

Gross profit Ratio = Gross Profit/ Sales x 100

This ratio helps in calculating the margin left after meeting all manufacturing costs. Higher gross profit ratio indicates efficient production and pricing.

Net Profit ratio

It measures the relationship between net profit and sales of
a firm.

Net profit Ratio = Net Profit/ Net Sales) x 100

This ratio enables determination of efficiency with which the business affairs are being carried out. An increasing trend in this ratio clearly illustrates improvement in conditions of the business. High net profit ratio ensures sufficient returns for the shareholders as well as provides a cushion for the firm to bear any adverse economic shocks.

Return on Investment

This ratio helps in determining the overall returns generated by the management with the assets possessed by the company. It can be calculated as:

Return on Investment = Operating Profit / Capital Employed

ROI measures the returns generated per unit of capital invested by the company.

Earnings Per Share (EPS)

It measures the per share profit available to the equity shareholders.

Earnings Per Share (EPS) = Net Profit available to equity shareholders / Number of oustanding ordinary shares

Price-earnings (P/E) Ratio

It reflects the price which the market is willing to pay for each unit of earnings of the firm.

Price-earnings (P/E) ratio = Market price of share / EPS

This ratio is widely used by stock market participants to determine whether to buy a particular stock or not at a particular price.

Activity Ratios

These ratios indicate the efficiency with which outstanding accounts or assets are converted into cash or sales. That is why these ratios are also called as turnover ratios. Higher the activity ratio, the better is the efficiency in utilisation of assets.

Some of the common activity ratios are:

  • Inventory turnover ratio
  • Debtors Turnover ratio
  • Creditors Turnover ratio
  • Assets Turnover ratio

Inventory turnover ratio

This ratio measures the speed with which the inventory is getting converted into sales.

Inventory turnover ratio = Cost of goods sold / Average inventory
Average Inventory = Opening stock + (Closing stock)

The higher the inventory turnover ratio, the better is the inventory management. A very low inventory turnover ratio indicates the opposite signifying excessive inventory.

Carrying too much inventory is not a financially viable proposition for the company as it represents cost in terms of storage, locking up of funds, interest and opportunity cost of blocked funds.

Debtors turnover ratio

This ratio indicates the pace with which receivables is collected from the debtors.

Debtors turnover ratio = Net credit sales / Average sundry debtors

Higher the debtors turnover ratio, the better is the credit management of the firm.

Creditors turnover ratio

It measures the speed with which payment is made to creditors.

Creditors turnover ratio = Net credit purchase / Average accounts payable

This ratio is a reflection of the promptness in payment to creditors. A high creditors turnover ratio indicates that the creditors are being paid quickly which enhances the credit worthiness of the firm. However, too high a ratio indicates that the credit facilities are not being taken full advantage of.

Assets turnover ratio

It indicates the efficiency of utilisation of assets to generate sales. It can be defined as:

Assets turnover ratio = Cost of goods sold / Average total assets

The higher the assets turnover ratio, the better the utilisation of assets while low ratio indicates suboptimal utilisation of available resources.

Importance of Ratio Analysis

  1. Measuring liquidity position
  2. Comparison of firms
  3. Assessing profitability
  4. Analysis of Trends
  5. Measuring operating efficiency or turnover of the firm

Measuring liquidity position

An important use of ratio analysis is to judge the liquidity position of the firm. A firm is said to have a satisfactory liquidity position if it is able to meet its short term liabilities.

Meeting short term liabilities will mean that the firm is able to repay back the interest as well as principal arising out of short term debt mostly within a year. Liquidity ratios are used by banks and other lending institutions to evaluate the short term repaying capability of any company.

Comparison of firms

Ratio analysis helps a company in conducting a reality check of its performance. An inter-firm comparison helps the company measure its performance vis-à-vis its competitors as well as overall industry.

Any large differences found between the firm and its competitors and industry call for a self-appraisal and adoption of appropriate remedial measures.

Assessing profitability

The management of any firm is constantly worried about the profitability of the firm as higher profits would mean that the firm will be able to meet its short term and long term obligations, generate sufficient returns for all stakeholders in the firm as well as help the firm build sufficient reserves to meet any eventuality. Ratios help in measuring the profitability of the firm.

Analysis of Trends

Evaluating the long term performance of the firm requires that its performance be tracked consistently over a period of time. Ratio analysis aids a company to check whether its performance is improving or declining over the years.

Trend analysis is significant because of the fact that one can know the movements in the performance of the firm i.e. whether they are in the direction desired by the firm or are they moving in an unfavourable direction.

Measuring operating efficiency or turnover of the firm

The ratios are useful in calculating the operating efficiency of the firm. Higher the operating efficiency of the firm better is the utilisation of the assets. Any management would like to have as high operating efficiency as possible as it represents best possible utilisation of the assets of the firm.

Limitations of Ratio Analysis

Although ratio analysis is a widely used tool in financial analysis, yet it suffers from various difficulties. Some of them are as follows:

  1. Requirement of Comparative Study
  2. Limitations of financial statements
  3. Changes in Price levels

Requirement of Comparative Study

Ratios make sense only if they are compared with their past performance or compared with other firms in the same industry. The problem that arises however in this is that comparison will be relevant only if same methodology for computing assets and liabilities has been used by the firm in the past as well and also by other firms in the industry.

Limitations of financial statements

Any calculation of ratios is based on the information contained in the financial statements. However, we know that financial statements themselves suffer from certain limitations and correspondingly ratio analysis as a tool also suffers from the same drawbacks.

For example, if there is a change in the management of the company, then it might lead to a change in the financial performance of the firm and hence the present and past performance becomes incomparable.

Changes in Price levels

The practice of financial accounting in India suffers from a major disadvantage that it does not into account changes in price level. This leads to distorted and misreported profits and incomparable financial statements.

Hence, ratios calculated on the basis of these financial statements would provide false picture of the status of the firm.

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