Ratio analysis is a quantitative method of analysing a firm’s financial conditions: it provides insight into the liquidity, operational efficiency, and profitability of a firm through the examination of various financial statements like balance sheets, income statements, profit and loss accounts, et cetera. Ratio analysis is a very useful financial tool in understanding a firm’s health: its importance can be explained from the perspective of both the firm’s management and investors in general.
From the point of view of the management, ratio analysis can be an essential tool to point out the strengths and weaknesses of the firm. Ratio analysis also plays a major role in capital budgeting (the process of determining long-term investments). From the perspective of investors, ratio analysis acts as a medium for the determination of important investment decisions in firms and companies. Ratio analysis helps an investor to measure the degree of risk associated with an organization as well as the expected rate of return from investing in it.
Ratio Analysis is majorly divided into six parts:
1. Liquidity Ratio: This ratio determines the potential of a company to pay short-term debts.
2. Solvency Ratio: This ratio determines the extent to which a company's assets can be required to cover debts.
3. Turnover/Activity Ratio: This ratio shows the operational efficiency of a company.
4. Profitability Ratio: As the name suggests, this ratio represents income earned by a company in relation to the cost incurred to generate that income.
5. Debt-Equity Ratio: This ratio indicates the relative proportion of shareholders' equity and debt used to finance a company's assets.
6. Earning Ratio- A key ratio in the investment decision-making process, this ratio is mainly used by investors of a company to get information about earning on their investment and the potential increase in the value of their investment in the future.
Two of these ratios play particularly important roles in the decision-making of both management and investors; these ratios will now be explained and analysed in depth.
As we saw, the Debt-Equity ratio represents the proportion of debt and shareholders' equity used to finance a company's assets. This ratio also determines the ability of a company to repay debts in the future during winding up its operations. This ratio plays a major role in allowing investors to make informed choices. For the management, this ratio helps them to determine the method through which they can raise capital in the future. The debt-to-equity (D/E) ratio is calculated by dividing a company's total liabilities by its shareholder equity. There is no ideal ratio but the lower the ratio, the better it is for investors. It is alarming when the ratio exceeds 2 because it implies that there are higher chances of zero compensation provided to that particular investor during the winding up of the company. In the eyes of management as well, this is not a favourable situation: as the debts increase, it leads to a reduction in operational flexibility of a company because banks and other financial institutions that provide loans to the company enjoy the rights to intervene in its management. When the ratio is low, the investor is in a safer position. On the other hand, management enjoys flexibility in operations with minimal intervention from outside. But what if the ratio is zero and the company is debt-free? This is not a favourable situation as well because in this situation the company couldn't enjoy the advantage of a "tax shield". A tax shield is an arrangement wherein the interests paid by companies come under ‘admissible expenses’ which lead to a reduction in tax that the company must pay. Hence, debt-free companies are not in the best position.
The Inventory Turnover Ratio is a measure to calculate the number of cycles of inventory sold in a given financial year. As mentioned previously, this ratio represents the operational efficiency of a company. This ratio is a great financial tool to get information about the day-to-day operations as well as its efficiency for both management as well as investors. This tool is also used in the decision-making process regarding pricing, manufacturing, and marketing. To calculate the inventory turnover ratio, the cost of goods sold is divided by the average inventory for the same period. The higher the ratio better it is for the company since it symbolizes greater operational efficiency. Lower Inventory Turnover Ratio represents poor operational efficiency which may affect the reputation of a company in the eyes of an investor. But in a few cases, even higher ratios have resulted in a shortage of inventory due to reasons like lack of proper investment, shortage of manpower, et cetera.