Financial Ratio Analysis

Financial ratio analysis involves calculating certain standardized relationship between figures appearing in the financial statements and then using those relationships called ratios to analyze the business' financial position and financial performance.

Due to varying size of businesses different comparison of two businesses is not possible. Certain techniques have to be applied in simplifying the financial statements and making them comparable. These include financial ratio analysis and common-size financial statements.

Ratios are divided into different categories such as liquidity ratios, profitability ratios, etc.

Categories of Financial Ratios

Liquidity Ratios

Liquidity is the ability of a business to pay its current liabilities using its current assets. Information about liquidity of a company is relevant to its creditors, employees, banks, etc. current ratio, quick ratio, cash ratio and cash conversion cycle are key measures of liquidity.

Solvency Ratios

Solvency is a measure of the long-term financial viability of a business which means its ability to pay off its long-term obligations such as bank loans, bonds payable, etc.. Information about solvency is critical for banks, employees, owners, bond holders, institutional investors, government, etc.. Key solvency ratios are debt to equity ratio, debt to capital ratio, debt to assets ratio, times interest earned ratio, fixed charge coverage ratio, etc.

Profitability Ratios

Profitability is the ability of a business to earn profit for its owners. While liquidity ratios and solvency ratios are relationships that explain the financial position of a business profitability ratios are relationships that explain the financial performance of a business. Key profitability ratios include net profit margin, gross profit margin, operating profit margin, return on assets, return on capital, return on equity, etc.

Activity ratios

Activity ratios explain the level of efficiency of a business. Key activity ratios include inventory turnover, days sales in inventory, accounts receivable turnover, days sales in receivables, etc.

Performance ratios include cash flows to revenue ratio, cash flows per share ratio, cash return on assets, etc. and they aim at determining the quality of earnings.

Coverage Ratios

Coverage ratios are supplementary to solvency and liquidity ratios and measure the risk inherent in lending to the business in long-term. They include debt coverage ratio, interest coverage ratio (also known as times interest earned), reinvestment ratio, etc.

Written by Obaidullah Jan, ACA, CFA