Top 5 Types of Ratio Analysis

The numerator and denominator of the ratio to be calculated are taken from the financial statements, thereby expressing a relationship with each other.

It is a fundamental tool that every company uses to ascertain the financial liquidity, debt burden, profitability, and how well it is placed in the market compared to its peers.

Top 5 Types of Ratio Analysis

Every company has calculated different types of ratios analysisRatios AnalysisRatio analysis is the quantitative interpretation of the company’s financial performance. It provides valuable information about the organization’s profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.read more to evaluate business performance. We may divide it as below:

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Type #1 – Profitability RatiosProfitability RatiosProfitability ratios help in evaluating the ability of a company to generate income against the expenses. These ratios represent the financial viability of the company in various terms.read more

This type of ratio analysis suggests the returns generated from the Business with the Capital Invested.

It represents the company’s operating profit after adjusting the cost of the goods that are sold. The higher the gross profit ratio, the lower the cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more, and the greater satisfaction for the management.

It represents the company’s overall profitability after deducting all the cash & no cash expenses: the higher the net profit ratio, the higher the The company’s net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company’s share capital (both equity and preference) as well as reserves and surplus.read morenet worthNet WorthThe company’s net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company’s share capital (both equity and preference) as well as reserves and surplus.read more, and the stronger the balance sheet.

It represents the soundness of the company and the ability to pay off its debt obligations.

ROCEROCEReturn on Capital Employed (ROCE) is a metric that analyses how effectively a company uses its capital and, as a result, indicates long-term profitability. ROCE=EBIT/Capital Employed.read more represents the company’s profitability with the capital invested in the business.

Type #2 – Solvency Ratios

These ratio analysis types suggest whether the company is solvent & can pay off the lenders’ debts or not.

This ratio represents the leverage of the company. A low d/e ratio means that the company has a lesser amount of debt on its books and is more equity diluted. A 2:1 is an ideal debt-equity ratio to be maintained by any company.

Where, total debt = long term + short term + other fixed payments shareholder funds = equity share capital + reserves + preference share capital – fictitious assets.

It represents how many times the company’s profits can cover its interest expenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more. It also signifies the company’s solvency shortly since the higher the ratio, the more comfort to the shareholders & lenders regarding servicing of the debt obligations and smooth functioning of the business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company’s goals like profit generation.read more of the company.

Type #3 – Liquidity Ratios

These ratios represent whether the company has enough liquidity to meet its short-term obligations or not. Higher liquidity ratios are more cash-rich for the company.

It represents the company’s liquidity to meet its obligations in the next 12 months. Higher the current ratio,Current Ratio,The current ratio is a liquidity ratio that measures how efficiently a company can repay it’ short-term loans within a year. Current ratio = current assets/current liabilities read more the stronger the company to pay its current liabilities. However, a very high current ratio signifies that a lot of money is stuck in receivables that might not be realized in the future.

Formula = Current Assets / Current Liablities

It represents how cash-rich the company is to pay off its immediate liabilities in the short term.

Type #4 – Turnover Ratios

These ratios signify how efficiently the assets and liabilities of the company are used to generate revenue.

Fixed asset turnoverFixed Asset TurnoverThe fixed asset turnover ratio formula determines the ability of a business entity to generate revenue by employing its fixed assets. It is computed as the fraction of net sales and average net fixed assets.read more represents the efficiency of the company to generate revenue from its assets. In simple terms, it is a return on the investment in fixed assets. Net SalesNet SalesNet sales is the revenue earned by a company from the sale of its goods or services, and it is calculated by deducting returns, allowances, and other discounts from the company’s gross sales.read more = Gross Sales – Returns. Net Fixed Assets = Gross Fixed Assets –Accumulated Depreciation.Average Net Fixed Assets = (Opening Balance of Net Fixed Assets + Closing Balance of Net Fixed Assets)/2.

The Inventory Turnover RatioInventory Turnover RatioInventory Turnover Ratio measures how fast the company replaces a current batch of inventories and transforms them into sales. Higher ratio indicates that the company’s product is in high demand and sells quickly, resulting in lower inventory management costs and more earnings.read more represents how fast the company can convert its inventory into sales. It is calculated in days signifying the time required to sell the stock on an average. The average inventory is considered in this formula since the company’s inventory keeps on fluctuating throughout the year.

Receivables Turnover Ratio reflects the efficiency of the company to collect its receivables. It signifies how many times the receivables are converted to cash. A higher receivable turnover ratio also indicates that the company is collecting money in cash.

#5 – Earning Ratios

This ratio analysis type speaks about the company’s returns for its shareholders or investors.

PE RatioPE RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more represents the company’s earnings multiple and the market value of the shares based on the pe multiple. A high P/E Ratio is a positive sign for the company since it gets a high valuation in the market for m&a opportunities.

Earnings Per ShareEarnings Per ShareEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more represents the monetary valueMonetary ValueMonetary value refers to the value of a product or service measured in terms of money. read more of the earnings of each shareholder. It is one of the major components looked at by the analyst while investing in equity marketsEquity MarketsAn equity market is a platform that enables the companies to issue their securities to the investors; it also facilitates the further exchange of these stocks between the buyers and sellers. It comprises various stock exchanges like New York Stock Exchange (NYSE).read more.

It represents how much profit the company generated with the invested capitalInvested CapitalInvested Capital is the total money that a firm raises by issuing debt to bond holders and securities to equity shareholders. Invested Capital Formula = Total Debt (Including Capital lease) + Total Equity & Equivalent Equity Investments + Non-Operating Cash read more from equity & preference shareholdersPreference ShareholdersA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more both.

Conclusion

The above mentioned are some ratios analysis types that the company can use for itsFinancial analysis is an analysis of finance-related projects/activities, company’s financial statements (balance sheet, income statement, and notes to accounts) or financial ratios to evaluate the company’s results, performance, and trends, which is useful for making significant decisions such as investment, project planning and financing activities.read more financial analysisFinancial AnalysisFinancial analysis is an analysis of finance-related projects/activities, company’s financial statements (balance sheet, income statement, and notes to accounts) or financial ratios to evaluate the company’s results, performance, and trends, which is useful for making significant decisions such as investment, project planning and financing activities.read more. In this way, ratio analysis is a very important tool for any kind of strategic business planning by the company’s top management.

This article has been a guide to Ratio Analysis Types. Here we discuss the top 5 types of ratio analysis, including profitability ratios, solvency ratios, liquidity ratios, turnover ratios, and earnings ratios, etc. You can learn more about financing from the following articles –

  • Limitations of Ratio AnalysisWhy Ratio Analysis is Important?Advantages of Ratio AnalysisFinancial Ratios Types