Understanding Financial Ratio Analysis

Financial Ratio analysis
This is the technique of comparing the relationship or ratio between two or more items of financial data from a company’s financial statement.
There are four categories of ratio analysis:
• Liquidity ratio
• Profitability ratio
• Solvency ratio
• Investment ratio

Liquidity ratio
This measures a company’s ability to pay its short-term obligations. Types of Liquidity ratios:
• Current ratio: current assets/current liabilities
• Acid test: (current assets-inventory)/current liabilities
• Inventory turnover: COGS/Av. Inventory
Profitability ratio
This is used to assess a Company’s to generate earnings relative to its revenue, operating costs, balance sheet assets or shareholders’ equity over time. Types of Profitability ratios:
• Profit margin: Net income/net sales
• Gross profit margin: Gross profit/ net sales
• Asset turnover: Net sales/Av. Total assets
Solvency ratio
This measures a company’s liquidity over a long period of time. Types of Solvency ratio:
• Debt to total assets: Total debts/total assets
• Interest coverage: EBIT/Interest expense
• Cash total debt coverage: Net cash provided by all activities/total liabilities
Investment ratios
This shows the profitability of shareholders’ investments. Types of Investment ratio:
• Return on Equity: The Return on Equity ratio measures a company’s profitability by looking at shareholder’s earnings from the investments of shareholders in the company. This is shows how well a company is able to utilise shareholders’ money.
• Payout ratio: The dividend payout ratio measures the percentage of net income that is distributed to shareholders on the form of dividends during the year. This shows the portion of profits the company decides to keep to fund operations and the portion of profits given to its shareholders.
• Dividend coverage(times): The dividend coverage ratio measures the number of times a company can pay dividends to its shareholders. This can be used by investors to estimate the risk of not receiving dividends.