If you are considering applying for or investing in a business, ratio analysis in accounting can help you determine whether the company is doing well financially.
With ratio analysis, you can find out the liquidity, efficiency and profitability of a business entity. In this article, we explore what ratio analysis is, what you can use it for and what you can learn from it and look at the types of ratio analysis.
Table Of Content
1 What is ratio analysis?
2 What is the use of ratio analysis?
2.1 Business trends
2.2 Competitive comparison
3 Types of ratio analysis in accounting
3.1 Profitability ratio
3.2 Liquidity ratio
3.3 Leverage ratio
3.4 Market value ratio
3.5 Efficiency ratio
4 Examples of ratio analysis in accounting
4.1 Profitability ratio
4.2 Liquidity ratio
4.3 Leverage ratio
4.4 Market value ratio
4.5 Efficiency ratio
What is ratio analysis?
Ratio analysis is an accounting method that uses financial statements, such as balance sheets and income statements, to gain insight into a company’s financial health. Ratio analysis will help determine various aspects of the organization including profitability, liquidity and market value.
Ratio analysis is a useful tool for determining from the outside what is going on in a business because the financial reports needed to perform ratio analysis are available to the general public. According To RajatArora Accounting Ratios and It’s Important
Company insiders usually do not use ratio analysis because they already have access to much more detailed information that would give them a better view of the company’s financial status.
What is the use of ratio analysis?
Ratio analysis compares the company’s financial condition with other companies or with its own financial history. Ratio analysis results are just static data, so you should compare them with other data to be useful.
Two ways you can use ratio analysis are to calculate business trends and compare one company to another in its industry.
Business trends
Trends help determine the direction of the financial aspects of a business, including whether profitability is rising or falling, whether the business is paying off or adding to debt, and how well the company is managing its assets under the new CEO compared to the old CEO.
You can determine the trend by calculating this ratio over multiple reporting periods. By comparing current ratios with past ratios, you can better predict the direction of your business in the future.
Competitive comparison
Another way to use ratio analysis is to compare your business with other businesses in the same industry. Businesses in the same industry will have similar capital structures and fixed assets. By comparing the results of this business ratio analysis, you can determine whether your business is an industry leader or simply competing with competitors.
Types of ratio analysis in accounting
There are many different types of financial ratios that you can use for ratio analysis, but the following general categories will tell you most of what you need to know to determine the financial status of a business:
Profitability ratio
A profitability ratio is a type of financial ratio that assesses the ability of a business to generate revenue in comparison to revenue, operating expenses, assets or shareholder equity.
You can use this ratio to find out how profitable a company is. There are several types of profitability ratios:
- Operating profit margin
- Gross profit margin
- Margin EBITDA
- Net profit margin
- Cash flow margin
- Return on equity
- Asset return
- Return on invested capital
A higher profitability ratio means the business is performing well. To assess whether a company has a higher ratio, you can compare the current ratio value with the historical value of other companies or companies in the same industry.
Liquidity ratio
The liquidity ratio, also known as the coverage ratio, works with ratio analysis to determine whether a company can pay off its short-term debt or not.
This ratio uses values from financial statements to compare assets and income with the amount of debt the business has. The term also refers to a company’s ability to use its assets to pay off its debts.
Here are some types of liquidity ratios:
- Fast ratio
- Current ratio
- Cash ratio
- Times interest earned ratio
- Days sales outstanding
A company that is more liquid than before or that of its competitors may be in for an economic boom, while a company whose debt is rising may not be the best investment.
Leverage ratio
The leverage ratio is also called the debt ratio or solvency ratio. Like liquidity ratios, leverage ratios deal with debt but with the aim of assessing a business’ ability to meet its long-term debt obligations rather than its ability to pay off its debts in the short term. Examples of commonly used leverage ratios include:
- Debt to equity ratio
- Debt to asset ratio
- Interest coverage ratio
The leverage ratio will give you a long-term view of the financial health of a business over time or in comparison to other companies.
Market value ratio
The market value ratio determines the current stock price of the company. Investors use these values to determine whether a business’s stock is overvalued or undervalued. As with other types of ratio analysis, there are several subtypes of market value ratios, including:
- Book value per share
- Dividend yield
- Earnings per share
- Market value per share
- Price/earnings ratio
You will usually see the market value ratio on a stock chart. Because they are well known, you can find averages for many industries to compare against a single company to determine its relationship to the market.
Efficiency Ratio
The efficiency ratio assesses how well the company uses its resources internally. Some of the things the efficiency ratio can calculate for you are:
- Accounts Payable Turnover
- Payment of obligations
- Equity quality
- Use of equity
- Inventory Turnover
- Equipment Turnover
You can compare this ratio with other companies in the same industry to determine how well the business is being managed. When a business increases in efficiency, it also increases its profitability.
Example of ratio analysis in accounting
To better understand the different types of ratios, consider the following calculation example:
Profitability ratio
The profitability ratio known as net profit margin is the ratio of a company’s net income to its revenue. The net profit margin tells you how well the company is converting its earnings into profit and allows investors to assess the health and financial stability of the company. The net profit margin formula is:
(Net profit / net sales) x 100 = net profit margin
If a company has revenues of 10,000,000 and makes a net profit of 2,000,000, you can calculate the net profit margin as follows:
2,000,000 / 10,000,000 = 0.20 or 20%
This results in a 20% net profit margin.
Liquidity ratio
One common liquidity ratio is the current ratio, which determines whether a company can pay off its current liabilities with its current assets. The higher the current ratio, the better their chances of doing this. The current ratio is:
Current ratio = current assets / current liabilities
Let’s say a company has current assets of 50,000 and current liabilities of 20,000. Using the current ratio formula, you would perform the following calculations:
50.000 / 20.000 = 2.5
This results in a current ratio of 2.5. This means the company has 2.5 current assets for every rupiah of its current liabilities.
Leverage ratio
To better understand the leverage ratio, you can use the debt-to-asset ratio as an example. This ratio helps business owners determine how much of a company’s total assets are financed through debt. The debt to assets ratio is:
(Short-term debt + long-term debt) / total assets = Debt-to-assets
Now let’s say the total assets of your company are 220,000,000 and the total outstanding debt is 40,000,000. Based on this information, you will perform the following calculations:
40,000,000 / 220,000,000 = 0.18 or 18%
This means that 18% of your company’s assets are funded through debt.
Market value ratio
The price/earnings ratio or P/E ratio evaluates a business by comparing its current share price with its earnings per share.
This ratio gives investors an idea of the relative value of a stock when compared to the P/E ratio of other companies. To calculate this value, you need to know the current stock price of the company, the number of shares outstanding, and the profit earned by the company. Here’s the price/earnings ratio:
P/E ratio = market value per share / earnings per share
Let’s say the company’s stock price closes at $90, its profit for the fiscal year is $12 billion and its outstanding stock makes $3 billion. You can calculate the earnings per share by dividing the profits by the shares outstanding to get $4. With this information, the company’s P/E ratio is:
$90 / $4 = 22,50
Efficiency Ratio
An efficiency ratio known as inventory turnover compares cost of goods sold to average inventory like so:
Inventory turnover = cost of goods sold / average inventory
This ratio lets you know how much inventory a company has and how efficiently it uses its inventory.
A high inventory ratio indicates that a company can move its inventory quickly. It features good inventory management and control.
Say you have a company whose cost of goods sold is 100,000,000 and that has a year-end inventory of 10,000,000. Using this information, you can determine its inventory turnover as follows:
100.000.000 / 10.000.000 = 10
