Being able to assess and understand an organisation's financial standing is critical in the field of investing, analysing, business ownership, and financial study. Financial numbers such as revenue, profit, and expenses mean nothing by themselves. There needs to be a connection and a comparison, and this is what financial ratio analysis is all about. It is a means of turning unprocessed financial data into meaningful insights relating to a company's performance, efficiency, stability and growth.
This guide aims to answer the question, what is financial ratio analysis, as well as the ratio analysis meaning, review the major financial ratios, and highlight the importance of financial ratio analysis in business operations. From a novice's perspective, this guide aims to be simple, while at the same time, sufficiently addressing the gaps to develop a clear and robust understanding of the subject.
Definition of Financial Ratio Analysis
Financial ratio analysis is the practice of analyzing and assessing the health and financial performance of an organization by computing the ratios of relevant financial statement items. Balance sheets, income statements, and cash flow statements are just a few examples of these financial statements.
The ratios, which are referred to as financial ratios, help determine how well a business has operated both today and in the past in relation to prior years, competitors, or a particular industry.
Ratio analysis, in simple terms, means looking for patterns in numbers and trying to understand what the numbers signify. There is a difference between the company's profit and how that profit was generated.
Knowing that a company has a profit of 100 crores is one thing, but knowing the profit it generated from the company's sales of the assets is far more informative. An explanation of financial ratios in this manner makes it more of a powerful analytical tool than a simple mathematical exercise.
Why Financial Ratio Explained and Analysed is Important
Financial ratio analysis can be seen as a diagnostic tool for the company. Just as a doctor looks at blood pressure, heart rate, and blood sugar levels together to determine the condition of the patient, financial analysts will look at financial ratios together to determine the condition of the company.
A financial ratio analysis makes it clear how financially stable a company is when paying off its short-term liabilities, how profitable it is, how much the company's capital structure is at risk, and how efficiently it utilises its resources. This analysis is what helps potential buyers, lenders, and company managers understand the different internal and external pressures of the company.
How Analysing Financial Ratios Functions
Analysing financial ratios starts by evaluating a company's financial statements and then relating them to relative perspectives. Instead of evaluating a company's performance with absolute values, ratios focus on a company's performance in proportion to one another and adjusting relationships. This gives the company a better opportunity to evaluate itself against past performance and compare itself to the industry, regardless of size.
Consider two competing firms in the same industry with a vast revenue disparity. Based on a profitability ratio, economically, one firm is better than the other or vice versa. Moreover, over the years, analysing the liquidity ratios of a certain firm gives an idea of whether the finances in the short term are getting better or worse. Financial ratios show the value of the firm.
Various Financial Ratios
At each level of a company's financial performance, there are multiple categories of financial ratios to choose from. These categories will offer you clarity to enhance your financial ratio analysis skills as well.
Liquidity Ratios
Liquidity ratios help determine a company's ability to meet its short-term financial obligations using current assets. Can a company pay its bills?
Liquidity ratios are especially useful for creditors and vendors. They help to determine if a company can meet its short-term financial commitments. Having strong ratios indicates financial stability and weak ratios could signal possible cash flow issues.
Profitability Ratios
Profitability ratios assess a company's success at making a profit. They demonstrate how effectively company management utilises inputs to produce outcomes.
Profitability analysis can provide insights into whether business models can become self-sustaining and grow. Poor profitability ratios can demonstrate rising costs or pressure on pricing, even with revenues increasing. Profitability ratios help explain the true earning capacity of a company.
Efficiency or Activity Ratios
Efficiency ratios help to assess how a company is using its own assets and how it is running its operations. These ratios concentrate on the turnover, speed and optimised utilisation of resources such as inventory, cash, accounts receivable and fixed assets.
Strong efficiency ratios often point to better management and operational discipline. They provide clues about the extent to which capital may be appropriately invested in productive activities, as opposed to being tied up inefficiently in the company.
Solvency Ratios
Solvency ratios look at a company’s long-term financial health and its ability to meet its long-term obligations. They help in assessing financial risk, as well as the capital structure.
When a company enjoys strong solvency ratios, it stands a better chance of weathering economic slumps and variations in interest rates. In this context, financial ratio analysis plays an important role in determining over-leverage versus sound financial structure.
Valuation Ratios
Valuation ratios are primarily used by investors to assess whether a company's stock is reasonably priced in the market, overvalued, or undervalued. The company's financial performance with respect to its market price is gauged by these ratios.
Valuation ratios are typically combined with expectations of growth and are used to determine the likely behaviour of a company’s share in the future. They are essential in equity research and portfolio construction.
Importance of Financial Ratio Analysis
The importance of financial ratio analysis lies in the fact that it helps users easily grasp the intricacies of financial data, thereby aiding in making prudent decisions. It serves as a bridge linking unprocessed financial data to actionable information.
Investors rely on financial ratio analysis to help pinpoint more sound companies, steer clear of financially shaky ones, and objectively evaluate several potential investment opportunities. Ratios provide a way to streamline analysis with less reliance on market gossip or short-term price fluctuations and more focus on the data.
For management, ratio analysis means more than just producing an external report. It monitors operational efficiency, cost containment, profitability improvement, and drives strategic planning. Analysis of internal ratios frequently drives budgeting, expansion, and other risk-related decisions.
Lenders and creditors focus on financial ratios and the company’s ability to pay back a loan. It is the liquidity and solvency ratios that lend the most insight into credit risk and lendability.
Beginner-Friendly Explanation of Financial Ratio Analysis
The level of financial ratio analysis required from an individual with no previous experience is simply that of asking the right questions. Is the business profitable? Is it viable in the short-term? Is the debt manageable? Are the assets being put to good use?
With financial ratios, even beginners can build a plan to analyse a company. This systematic way of thinking will help reduce the level of uncertainty and reliance on emotion over time.
Limitations of Financial Ratio Analysis
Despite being a useful tool, the drawbacks of financial ratio analysis cannot be ignored. Ratios consider past accounting data which may have no bearing on future performance. Also, a change in accounting standards may impact any ratio comparisons made.
Furthermore, one should not consider financial ratios independently. A financial ratio by itself may have no merit. The number must be supplemented with context, current trends within the industry, the overarching economic situation and any qualitative variables.
Being aware of the aforementioned issues is a critical component of responsibly and effectively employing financial ratio analysis.
How to Use Financial Ratios Effectively
Effective financial ratio analysis requires a methodology characterised by consistency and comparison. Instead of relying on a single data point, ratios must be analysed across multiple time periods to discern patterns. Furthermore, the accuracy of the analysis improves significantly when ratios from one company are compared to the industry average.
Another practical, but critical aspect when carrying out ratio analysis, particularly financial ratios, is the use of multiple ratios. Using liquidity, profitability and solvency ratios on a company provides a complete picture of the company’s financial position and minimises the risk of incorrect judgments from the analysis.
Conclusion
To sum up, one of the most effective methods in finance for figuring out a company's actual financial situation is financial ratio analysis. We may assess companies impartially and wisely by defining financial ratio analysis precisely, investigating the purpose of ratio analysis, and comprehending different financial ratios.
Financial ratio analysis is crucial for academic research, lending, investing, and management. It turns financial statements from complicated numbers into insightful information that helps make wise financial decisions when applied properly and contextually. Gaining proficiency in financial ratio analysis is crucial for long-term success in the financial industry, regardless of experience level.
DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.
