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Concept and meaning of Ratio Analysis

Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of
ratio to interpret the financial statements so that the strength and weaknesses of a firm as well as
its historical performance and current financial condition can be determined. The term ratio
refers to the numerical or quantitative relationship between two variables.

Ratio analysis is a method of analyzing data to determine the overall financial strength of a
business. Financial analysts take the information off the balance sheets and income statements of
a business and calculate ratios that can then be used to make assessments of the operating ability
and future prospects of that business. These ratios are useful only when compared to other ratios,
such as the comparable ratios of similar businesses or the historical trend of a single business
over several business cycles. There are various ratios that measure a company's efficiency, short-
term strength, profitability, and solvency.

Importance of ratio analysis:

It helps in evaluating the firm’s performance:

  With the help of ratio analysis conclusion can be drawn regarding several aspects such as
financial health, profitability and operational efficiency of the undertaking.

  Ratio points out the operating efficiency of the firm i.e. whether the management has utilized the
firm's assets correctly, to increase the investor's wealth.

  It ensures a fair return to its owners and secures optimum utilization of firm’s assets.

  The information given in the basic financial statements serves no useful Purpose unless it s
interrupted and analyzed in some comparable terms.

  The ratio analysis is one of the tools in the hands of those who want to know something more
from the financial statements in the simplified manner.

Types of Ratio Analysis

Liquidity Ratio

Liquidity ratios aid decision makers in evaluating creditworthiness. Lenders want to ensure that
their borrowers are able to pay back their loans and agreed interest. Liquidity ratios compare a
company's assets against their obligations. For example, the current ratio, calculated current
assets over current liabilities, tests how many times liquid assets will cover regular bills. Some
other liquidity ratios are the quick ratio and the cash ratio.

These ratios provide an idea about well a company is situated to meet its current liabilities.
Investors get this information by comparing a company's current assets with its current liabilities.
If the company has an adequate level of assets to pay its liabilities, that is a positive sign.
Analysts consider a liquidity ratio of two to be healthy since it indicates that the company has
enough assets on hand to meet its current liabilities. If the company does not have adequate
assets to meet its upcoming liabilities, investors should investigate further.

Leverage Ratio

Leverage is another word for debt. Companies use bank financing to help expand business, but
too much debt can lead to problems and it can be a sign of a struggling company. Leverage ratios
help managers determine if a company is using too much debt. The debt ratio, determined by
dividing total liabilities by total assets, will tell you if a company can cover its debts if it
liquidates. Other debt ratios include debt to equity, interest coverage ratio and capitalization
ratio.

These ratios give an idea about how much debt a company has on its books. If the company uses
its debt to generate better earnings for shareholders, analysts view use of debt positively. One
common leverage ratio, the debt-to-equity ratio, looks at a company's debt levels and compares
that to the company's equity. Another way of looking at leverage is to get an idea about how
much money a company has available to meet its interest payment obligations. It is a healthy
sign if a company has enough money on hand to meet its interest payment commitments. On the
other hand, it is a bad sign if a company is not generating adequate earnings to cover its debt
servicing.

Profitability Ratio

When evaluating a number of profitable companies and looking to find which one is more
profitable, you must utilize profitability ratios. Profitability ratios test a company's ability to
generate income. Net profit margin, which is net income divided by net sales, will tell you how
much of the sales is left over after paying all expenses. Several other profitability ratios include
return on investment, return on assets and return on equity.

The purpose for a company's existence is to make a profit for its shareholders. It is important to
see how well the company is doing in this respect. The ratios that provide this input are grouped
together as profitability ratios. The gross profit margin measures what sort of profit a company is
generating from its sales after deducting the cost of the goods sold. It is a basic ratio that does not
take into account other costs that companies incur. Return on equity is another profitability ratio
that measures how much of a return the company is getting on the equity it has invested. This
ratio is generated by dividing a company's earnings by the total shareholder's equity invested in
the business. This gives investors an idea about how profitable a company is too. It is not easy to
standardize profitability ratios since profits vary from one industry to another.

Efficiency Ratio

No two companies operate the same way. Using efficiency ratios helps identify companies that
manage finances efficiently. The purpose of any company is to convert assets into sales. The
asset turnover ratio (net sales divided by average total assets), will indicate how much of a
company's assets have been sold. Other efficiency ratios include accounts receivable turnover,
cash turnover and days payable outstanding.

No two companies operate the same way. Using efficiency ratios helps identify companies that
manage finances efficiently. The purpose of any company is to convert assets into sales. The
asset turnover ratio (net sales divided by average total assets), will indicate how much of a
company's assets have been sold. Other efficiency ratios include accounts receivable turnover,
cash turnover and days payable outstanding