Ratio Analysis: Types, Definition and Formula

Ratio analysis rests on the data provided by the financial statements which provide information about a firm’s financial position at a point in time. With the help of ratio analysis, we can analyze a firm’s current financial health and predict its financial position in the future.

Main Groups of Ratios

The most common types of ratios are liquidity ratios, asset management ratios, debt management ratios, profitability ratios, and market value ratios.

1. Liquidity Ratios

Liquidity ratios reflect how well the firm is able to meet its current obligations with its existing current assets.

• Current ratio = Current assets / Current liabilities
• Quick ratio = (Current assets – Inventories) / Current liabilities
• Cash Ratio = Cash / Current liabilities

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2. Asset Management Ratios

Asset management ratios measure how effectively the firm is managing its assets.

• Inventory turnover ratio = Sales / Inventories
• Days sales outstanding (DSO) ratio = Receivables / Average sales per day

= Receivables / Sales/360

• Fixed asset turnover ratio = Sales / Net fixed assets
• Total assets turnover ratio = Sales / Total assets
• Operating capital requirement ratio = Operating capital / Sales

3. Debt Management Ratios

Debt management ratios check balance sheet ratios to determine  the extent to  which borrowed funds have been used to finance assets ,and review income statement ratios to determine how well operating profits cover fixed charges such as interest.

• Leverage Ratios
  • Debt ratio = Total debt / Total assets
  • Debt to equity ratio = Total debt / Total equity
  • Short-term debt / Total debt ratio
• Coverage Ratios
  • Times interest earned ratio = EBIT / Interest expense
  • EBITDA coverage = (EBIT + Lease payments + Depreciation & Amortization) / (Interest expense + Lease payment + loan payment)

4. Profitability Ratios

Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating results.

• Profitability of Sales:
  • Net profit margin = Net income / Sales
  • Gross profit margin = (Net sales – cost of goods sold) / Net sales
• Profitability of Assets
  • Return on assets (ROA) = Net income / Total assets
  • Basic earning power = EBIT / Total assets
• Return on Equity (ROE) = Net income available to common stockholders / Common equity

5. Market Value Ratios

Market value ratios cover a group of ratios that relates the firm’s stock price to its earnings and book value per share. They give management  an indication of what investors think of the company’s past performance and future prospects.

• Price / Earnings Ratio (P/E) = Price per share / Earnings per share
• Market / Book Ratio (M/B) = Market price per share / Book value per share

The Bottom Line

Ratio analysis is used to determine in which direction the firm is heading. It’s important to know that we should compare several numbers together in order to gain better insights. The other important thing to know is that comparing the firm’s performance with a firm of similar size in the same industry is needed for financial ratio analysis.

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