It is a method of analyzing a company’s financial statements or line items within financial statements. It helps to compare business performances in 2 ways – using past data (historical comparisons of the same company TRENDS) and using current comparisons between different companies in the same industry.
It is quite easy to compare business performance using one year’s figures with those from the previous year or years. Similar comparisons can be made between different companies as well. Inter-business comparisons involve comparing the same ratio in the same time period for two or many different businesses. Such comparisons show RANKS, thereby helping managers to assess the financial performance of businesses against similar firms.
Types of Ratios
A. Profitability ratios as known as Common side ratios (Net profit margin and return on shareholder’s equity)
B. Liquidity ratios (Working capital) – measure your company’s ability to cover its expense, on the balance sheet.
C. Debt or Leverage ratios (debt to equity and debt to asset ratios)
D. Operations ratios (inventory turnover)
E. Market ratios (Earnings per share)
Net profit margin: Gross profit minus expenses. Company’s net income divided by Revenue/Net sales.
Return on assets ratios: this helps you determine how effectively a company is using its assets to generate profit. The higher the ratio, the more profit each dollar in assets produces. It is calculated by dividing net income by Total assets.
Operating margin ratios: This uses operating income and revenue to determine the profit a company is getting from its operation. This ratio, along with the Net profit margin, can give investors a good feel for the profitability of a company as a whole. Net operating income divided by total revenue.
Return on equity ratios: This is another way to gauge profitability. It measures how well a company generates profit using money that’s been invested in it (shareholder’s equity). Net profit divided by Total equity.
Current ratios: These reflect financial strength. It is the number of times a company’s current assets exceed its current liabilities, which is an indication of the solvency of that business. The current ratio equals total current assets divided by total current liabilities.
Inventory Turnover: This measures the number of times inventory “turned over” or was converted into sales during a time period. It is a good indication of purchasing and production efficiency. It is the cost of goods sold divided by inventory. The higher the cost of sales to inventory ratio, the better. A high ratio shows that inventory is turning over quickly, and that little unused inventory is being stored.
Debt to worth ratio: It is a measure of how dependent a company is on debt financing as compared to owner’s equity. It shows how much of a business is owned and how much is owed.
Debt-to-equity ratio: it compares a company’s total liabilities with its shareholder equity and can be used to assess the extent of its reliance on debt. D/E ratios vary by industry and are best used to compare direct competitors or to measure the change in the company’s reliance on debt over time. Among similar companies, a higher D/E ratio suggests more risk, while a particularly low D/E ratio may indicate that a business is not taking advantage of debt financing to expand.
