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Ratio Analysis is one of the techniques in financial analysis to know the financial condition of a business concern. Ratio analysis is just a comparison of various, relevant accounting figures, is called accounting ratios. It’s not so easy to tell how a business concern is doing just by looking at the financial statements. How the company is doing will be known by applying the methods of ratio analysis. A thorough quantitative analysis of financial information is done by using the concepts of ratio analysis.
Ratio analysis uses ratios to know the financial health of a company. Among dozens of financial ratios available, the most important ratios are:
- Liquidity Measurement Ratios
- Profitability Indicator Ratios
- Debt Ratios
- Operating Performance Ratios
- Cash Flow Indicator Ratios
- Investment Valuation Ratios
Liquidity Measurement Ratios
- Current Ratio: Current ratio is one of the most important and famous ratio. Its used to know the Current or working capital of the company. The concept is to find whether a company’s current assets can pay-off the current or short-term liabilities. The formula is: Current Ratio = Current Assets / Current Liabilities.
- Quick Ratio: Quick Ratio or Acid-test Ratio is the liquidity indicator in a company.
It is known by using current assets – inventory / Current Liabilities.
- Cash Ratio: Cash ratio is used to know whether the company’s cash or cash equivalent, I.e. shares and bills receivables, etc./ Current Liabilities
Profitability Indicator Ratios
- Profit Margin Analysis: It is a comprehensive analysis of profit on sales. The amount of profit /per sales or per capita income from each sale is known by using this ratio.
It includes Gross Profit Margin = Gross profit / Net Sales (Revenue)
Operating Profit = Operating Profit / Net sales (Revenue)
Net Margin Profit = Net Margin / Net sales (Revenue)
- The Ratio indicates how profitable the company is relative to its total assets. The formula is Return on Assets = Net income /Average total assets.
Return on Equity: The ratio is useful in finding the net income and comparing them to the shareholder’s equity.
Return on equity = Net Income / Average Shareholders’ Equity.
Debt Ratios
Debt Ratio compares the total debt to its total assets, which gives the picture of the amount of leverage enjoyed by the company. Debt Ratio = Total Liabilities / Total Assets.
- Debt-Equity Ratio: Another angle of leverage is debt-equity ratio which like the previous ratio compares the company’s position of liabilities to its equity. The formula is Total Liabilities / Shareholder’s Equity.
- Cash Flow to Debt Ratio: This ratio compares the total debt to the operating cash flow. The formula is Operating Cash Flow / Total Debt
- Operating Performance Ratios: These ratios tell how productive the company’s assets are. They tell as to how efficiently and effectively the company is utilizing its resources.
- Fixed-Assets Turnover Ratio: This is a rough measure of a company’s fixed assets to its sales. The formula is Revenue / Property, Plant & Equipment
- Sales/ Revenue per Employee: It’s a gauge of personnel productivity. This ratio measures the amount of currency sales, or revenue generated per employee. The formula is Revenue / Number of employees (Avg.)
Cash-Flow indicator Ratios
- Operating cash flow/ sales ratio: This ratio measures the operating cash flow to its net sales or revenues. It would be worrying to see a company’s sales grow without a proportional growth in cash flow. The formula is Operating cash flow / Net Sales (revenue)
- Free Cash Flow/ Operating Cash Flow Ratio: This ratio measures the relation between free cash flow and operating cash flow. Free cash flow is defined as operating cash flow minus capital expenditure. The formula is Free cash flow (operating cash flow – capital expenditure)/ Operating Cash Flow.
- Dividend payout ratio: This ratio defines the amount of earnings per equity share allocated to paying cash dividends to shareholders. It’s an indicator of how well the earnings support the dividend payment. The formula is Dividend per common share/ Earnings per share.
Investment Valuation Ratios
- Price/ Book Value Ratio: This ratio compares the market price of shares and the book value of the shares. Its an indication of how much the shareholders are paying for the net assets of the company. The book value of a company is the value of a company’s assets shown in the balance sheet. It is the difference between the assets and liabilities in the balance sheet and is an estimation of the value if it were to be liquidated. The formula is Stock per share/ Shareholders’ Equity per share.
- Price/ Cash flow ratio: The ratio compares the stock’s market price to the amount of cash flow the company generates on a per-share basis. The formula is Stock per share/ Operating cash flow per share.
- Price/ Earnings ratio: The ratio gives the picture of how many times the stock is trading (its price) per each dollar of Earnings Per Share. The formula is Stock Price per Share/ Earnings per Share (EPS)
- Price/ Sales Ratio: The ratio measures the price of a company’s stock against its annual sales, instead of earnings. The formula is Stock Price per Share/ Net Sales (Revenue) per share.
- Dividend Yield Ratio: It is defined as the annual cash dividend per share divided by the current price of the stock. The formula is Annual dividend per share/ Stock Price per share.
- Enterprise Value Multiple: It is calculated by dividing the company’s enterprise value by its earnings before interest expenses, taxes, depreciation and amortization. The formula is Enterprise Value/ EBITDA.
Ratio Analysis is one of the techniques in financial analysis to know the financial condition of a business concern. Ratio analysis is just a comparison of various, relevant accounting figures, is called accounting ratios. It’s not so easy to tell how a business concern is doing just by looking at the financial statements. How the company is doing will be known by applying the methods of ratio analysis. A thorough quantitative analysis of financial information is done by using the concepts of ratio analysis.
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