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A Quick Guide To Master Ratio Analysis

Financial statements contain financial data about a company. Ratio analysis is the key tool used to analyze and interpret the financial data of a company. If you want to work as a financial analyst, this is one of the most important tools to have in your repertoire. Company shareholders, business analysts, and other stakeholders use ratio analysis extensively to interpret financial data.

Financial ratio analysis is a quantitative tool to understand the company’s financial position, cash flows, long-term trends, and capital structure decisions as it impacts its profitability, leverage, and the market price of the company’s share price. Chartered Financial Analysis course gives you an in-depth understanding of Financial Statement Analysis. If you are pursuing a CFA course in India, you can do a financial analyst’s course online at https://imarticus.org/.

An Overview of Financial Ratio Analysis

Calculated ratios can be fractions, number of times, ratios, or percentages. The key presumption is that data contained in the financial statements is accurate for ratio analysis to deliver an accurate picture of the company’s financial health. Also, a relationship between the numbers is essential when comparing two accounting numbers. Moreover, a company’s ratio analysis alone is not enough; you have to analyze its peers to do an inter-firm comparison and an industry analysis. 

Accounting ratios are classified into:

  1. Solvency ratios
  2. Liquidity ratios
  3. Activity or turnover ratios
  4. Profitability ratios
  5. Liquidity ratios: These ratios measure the company’s short-term solvency and its ability to meet its short-term obligations in the form of short-term bank loans and payables. It examines how quickly its short-term assets are converted into cash. This determines the company’s ability to meet its short-term obligations. 

Ratios under this include:

  • Current ratio (current assets / current liabilities)
  • Quick ratio (cash + short-term investments accounts receivable)/ Current liabilities
  • Cash ratio (cash and cash equivalents) / Current liabilities
  • Working capital cycle: Inventory days + receivable days – payable days

Solvency ratios: These ratios measure the company’s ability to repay its long-term liabilities. It also analyses the efficacy of the capital structure decision and measures the total amount of debt capital compared to the equity capital in the company. It analyses whether the earnings and cash flows are sufficient to repay the principal of its borrowed capital and make interest payments. 

Ratios under this category include:

  • Debt to total assets: Total debt (short term + long term) / total assets
  • Debit to capital : Total debt (short-term debt + long-term debt) / (debt + equity + reserves)
  • Debt/Equity: Total debt (short-term debt + long-term debt) / (equity + reserves)
  • Interest Coverage Ratio: Earnings before interest, depreciation and amortization, and taxes/interest

Profitability ratios: These ratios measure the company’s ability to generate profits against sales, operating costs, total assets, and the company’s equity.

Ratios under this metric include the following:

  • Gross profit margin: Gross profit / net sales revenue
  • Operating profit margin: Operating profit / net sales revenue
  • Pre-tax profit margin: Earnings before interest, depreciation, amortization, and taxes / net sales revenue
  • Net income: Net profit / net sales revenue
  • Return on assets: Net profit / total assets
  • Return on equity : Net profit / equity

Chartered Financial Analysis course gives you an in-depth understanding of Financial Statement Analysis. If you are pursuing a CFA course in India, you can do a financial analyst’s course online at https://imarticus.org/.

Turnover ratios: These ratios analyze how long it takes to convert accounts receivable and company inventory into cash. Ratios under this category include:

  • Receivables turnover ratio: Accounts receivable / sales
  • Days receivable: Number of days in a year/accounts receivable turnover
  • Inventory turnover: Cost of goods sold / inventory turnover
  • Days inventory: Number of days in a year/inventory turnover
  • Accounts payable turnover: Accounts payable / purchases
  • Days payable: No. of days in a year/accounts payable turnover
  • Cash conversion: Receivable days + inventory days – payable days
  • Asset turnover days: Total assets/sales
  • Fixed assets turnover: Total fixed assets/ sales
  • Equity turnover : Total sales / equity
  • DuPont ROE analysis: Net profit/ sales x sales/total assets x total assets/ shareholders equity

Business risk: Business risk is analyzed by operating leverage, financial leverage, and total leverage

  • Operating leverage = % change in net profit to % change in sales
  • Financial leverage = % change in the net Income to % change in EBITDA
  • Total leverage is a product of operating leverage and financial leverage

Per-share ratios include:

  • Earnings per share= Net profit / total number of outstanding shares of the equity capital of the company
  • Dividend per share = Total dividend paid / total number of outstanding shares of the equity capital of the company
  • Price to earnings = Market price of the share/earnings per share
  • Price to book value = Market price per share/book value per share
  • Bid-Ask spread = Difference between the highest price the buyer is willing to pay for the share compared to the lowest price the seller is willing to sell.

These are key ratios used to analyze a company. Most ratios are interlinked and have to be looked at cohesively. A Chartered Financial Analysis course gives you an in-depth understanding of a Financial Statement Analysis using ratio analysis. 

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