What is Financial Ratio Analysis?

Financial Ratio Analysis

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Financial Ratio Analysis

Financial ratio analysis is a method of analyzing a company’s financial performance by comparing various financial figures from its financial statements. These ratios simplify complex financial data and allow for more straightforward comparisons over time, against industry peers, or versus industry averages. This information is helpful for stakeholders like managers, investors, creditors, and analysts in making informed decisions.

There are several types of financial ratios, each serving a unique purpose:

  • Liquidity Ratios: These measure a company’s ability to meet short-term obligations. Examples include the current ratio (current assets / current liabilities) and the quick ratio ((current assets – inventory) / current liabilities).
  • Solvency Ratios: These measure a company’s ability to meet long-term obligations. Examples include the debt-to-equity ratio (total debt / total equity) and the equity ratio (equity / total assets).
  • Profitability Ratios: These measure a company’s ability to generate profits. Examples include the net profit margin (net income / revenue), return on assets (net income / total assets), and return on equity (net income / total equity).
  • Efficiency Ratios: These measure how efficiently a company uses its assets and manages its liabilities. Examples include the inventory turnover ratio (cost of goods sold / average inventory) and the receivables turnover ratio (net credit sales / average accounts receivable).
  • Market Value Ratios: These measure the market perception of a company’s future prospects. Examples include the price-to-earnings ratio (market price per share / earnings per share) and the dividend yield (annual dividends per share / market price per share).

Each ratio provides a different perspective on the company’s financial health, and they are often used together for a more comprehensive analysis. It’s also important to note that ratios should be used in context — they should be compared to historical data, industry norms, and relevant benchmarks to draw meaningful conclusions.

Example of Financial Ratio Analysis

Let’s imagine we have a company, “Example Corp.” We’ll look at a few key ratios based on the following financial data:

  • Revenue: $500,000
  • Net Income: $50,000
  • Current Assets: $200,000
  • Current Liabilities: $100,000
  • Total Assets: $500,000
  • Total Equity: $300,000
  • Total Debt: $200,000
  • Cost of Goods Sold: $200,000
  • Average Inventory: $50,000
  • Market Price Per Share: $20
  • Earnings Per Share: $1

Here are some of the ratios we might calculate:

  • Liquidity Ratio
    \(\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{\$200,000}{\$100,000} = 2.0 \)
    This suggests that Example Corp. has twice as many current assets as current liabilities, indicating a good short-term financial health.
  • Solvency Ratio
    \(\text{Debt-to-Equity Ratio} = \frac{\text{Total Debt}}{\text{Total Equity}} = \frac{\$200,000}{\$300,000} = 0.67 \)
    This ratio suggests that for every dollar of equity, Example Corp. has $0.67 in debt, which might be acceptable depending on the industry norm.
  • Profitability Ratio
    \(\text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}} = \frac{\$50,000}{\$500,000} = \text{0.10, or 10%} \)
    This means that Example Corp. is making a net profit of 10 cents for each dollar of revenue.
  • Efficiency Ratio
    \(\text{Inventory Turnover} = \frac{\text{Cost of Goods Sold}}{\text{Average Inventory}} = \frac{\$200,000}{\$50,000} = 4.0 \)
    This suggests that Example Corp. turns over its inventory 4 times per year.
  • Market Value Ratio
    \(\text{Price-to-Earnings Ratio} = \frac{\text{Market Price Per Share}}{\text{Earnings Per Share}} = \frac{\$20}{\$1} = 20 \)
    This suggests that investors are willing to pay $20 for each dollar of Example Corp’s earnings, which can be compared with other companies in the same industry to evaluate if the stock is over- or under-valued.

Remember, these ratios are most meaningful when compared over time, against other companies, or against industry averages. They provide a quick snapshot of various aspects of a company’s financial health.

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