📘 1. Ratio Analysis

🔹 Definition

Ratio analysis is a quantitative tool used to evaluate a company’s financial performance by comparing figures from its financial statements—primarily the balance sheet and income statement. It helps stakeholders assess profitability, liquidity, efficiency, and solvency.

🔹 Purpose

  • Evaluate financial health

  • Compare with industry benchmarks or competitors

  • Analyze trends over time

  • Support decision-making (e.g., for investors, creditors, management.

 

📊 2. Types of Ratios

There are four major categories of financial ratios:

  1. Liquidity Ratio
  2. Solvency Ratio
  3. Profitability Ratio
  4. Efficiency Ratio

📌 3. Interpretation of Financial Ratios

  • High Liquidity Ratios = Safe in short-term, but excessive liquidity might mean underutilized assets.

  • High Solvency Ratios (debt-heavy) = Risky, especially during downturns.

  • High Profitability Ratios = Indicates effective cost control and pricing strategy.

  • High Efficiency Ratios = Reflect optimal use of resources.

🔎 Benchmarking

Ratios must be compared to:

  • Industry averages

  • Previous years (trend analysis)

  • Key competitors

⚠️ 4. Limitations of Financial Ratios

  • Historical Data: Based on past performance, may not reflect future conditions.

  • Window Dressing: Firms may manipulate timing of transactions to look better.

  • Different Accounting Methods: Can distort comparisons.

  • No Qualitative Insight: Doesn’t capture customer satisfaction, employee morale, etc.

  • Industry Differences: Some ratios are more relevant in some industries than others.

✅ 5. Practical Examples

Example: XYZ Corp.

Metric Value
Revenue $1,000,000
COGS $600,000
Net Income $150,000
Current Assets $400,000
Inventory $100,000
Current Liabilities $200,000
Total Assets $800,000
Total Liabilities $300,000
Equity $500,000
Interest Expense $20,000
EBIT $170,000

Key Ratios:

  • Current Ratio = 400,000 / 200,000 = 2.0

  • Quick Ratio = (400,000 – 100,000) / 200,000 = 1.5

  • Debt-to-Equity = 300,000 / 500,000 = 0.6

  • Gross Margin = (1,000,000 – 600,000) / 1,000,000 = 40%

  • Net Margin = 150,000 / 1,000,000 = 15%

  • ROE = 150,000 / 500,000 = 30%

  • Interest Coverage = 170,000 / 20,000 = 8.5 times

📌 Summary Table

Ratio Type Key Focus Ideal Direction
Liquidity Short-term ability Higher
Solvency Long-term stability Lower (debt)
Profitability Earning ability Higher
Efficiency Resource utilization Higher
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