What is Ratio Analysis?

Ratio analysis is a method of quantitative analysis for gaining better insight of any company’s liquidity position, profitability and operating performance by studying financial instruments such as balance sheet, cash flow statement and income statement.

It is one of the most important methods in fundamental analysis. Investors and financial analysts use this method to analyze financial health of the company. Ratios are used for comparisons between the companies and likely to measure company’s performance in the history and in the near future.

Types of Ratios in Ratio Analysis:

  1. Liquidity Ratio: It is used to find debtors ability to pay off the current liability obligations without raising external capital or funding. With liquidity ratios, current liabilities are most often analyzed in relation to liquid assets. 

  1. Solvency Ratio:  It is used to measure the long-term health of any business. Solvency ratios can prove that business firms can pay their debt obligations. It is also used to help the business owner to keep track of business downtrends that could lead the potential future bankruptcy. 

  1. Profitability Ratio: As the name clarifies it accesses the ability to generate earnings relative to its revenue, operating costs, balance sheet assets and shareholders equity. 

  1. Efficiency Ratio: This ratio is usually used to analyze to know how well a company uses its assets and liabilities internally. It is also known as the activity ratio and analyses the performance of company’s short term and current performances.  

  1. Coverage ratio: It is used to analyze that company’s ability to service its debts and meet its financial obligations, such as interest payments or dividends. Low coverage ratio does not mean that the company's future is in trouble or company’s facing any financial difficulties. 

Use of Ratio Analysis:

  1. Comparisons: The primary use of ratios is to compare the company’s financial performance to similar in the industry to understand the company’s position in the market. The management can use the information to formulate the decision to improve the company’s position in the market. 

  1. Trend Line: Companies use ratio analysis to find if there is any trend in financial performance. The trend obtained from these ratios can be very important to predict the direction of future performance of the company. 

  1. Operational Efficiency: Companies use ratio analysis to determine the degree of efficiency in the management of assets and liabilities. Inefficient use of assets like motor vehicles, land, old furniture that needed to be eliminated.

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