🔍Introduction : Ratio analysis is one of the most powerful tools in financial analysis. Whether you’re an investor, manager, banker, or just a curious learner, ratios help you make sense of complex financial statements. By analyzing numbers from the balance sheet and income statement, we can uncover a company’s true financial health.
🎯Objectives of Ratio Analysis
Here’s what ratio analysis helps us do:
1. Evaluate Financial Performance — Measure profitability, efficiency and solvency.
2. Benchmark Against Industry Standards — Compare performance with peers.
3. Support Decision-Making — Aid both internal managers and external stakeholders.
4. Track Trends Over Time — Spot patterns in performance across different periods.
5. Assess Creditworthiness — Important for lenders and creditors before financing.
📘Categories of Financial Ratios
1. 💧 Liquidity Ratios
These measure a company’s ability to meet short-term obligations out of short term assets.
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio (Acid Test) = (Current Assets – Inventory) / Current Liabilities
- Net Working Capital (NWC) or Margin or Liquid Surplus = Current Assets – Current Liabilities
(Or: Long-term Sources – Long-term Uses)
2. 🏦 Solvency Ratios
Help evaluate long-term financial stability and dependence on debt.
- Debt Equity Ratio = Debt / Equity or Term Liabilities / Tangible Net Worth
- Financial Leverage Ratio = Total Outside Liabilities / Tangible Net Worth
- Debt Service Coverage Ratio (DSCR) = (Profit After Tax + Depreciation + Interest on Term Loan) / (Principal Repayment of TL + Interest + Interest on TL)
3. ⚙️ Activity Ratios
Show how efficiently a company utilizes its assets.
- Asset Turnover Ratio = Net Sales / Net Tangible Assets
- Stock Turnover Ratio = Cost of Goods Sold (Cost of Goods
Sold) / Average Inventory- COS = Net Sales – Gross Profit
- Average
Inventory = (Opening + Closing Stock) / 2
- Debtors’ Period = Average Sundry Debtors / Average Daily Credit Sales
- Average Sundry Debtors = (Opening + Closing Debtors)/2
- Creditors’ Period = Average Sundry Creditors / Average Daily Credit Purchases
4. 💰 Profitability Ratios : Assess a company’s ability to generate profits.
- Return on Investment (ROI) = (PAT / Total TangibleAssets) × 100
- Return on Equity (ROE) = (PAT / Net Worth) × 100
✅Benefits of Ratio Analysis
✔️Simplifies complex financial data
✔️ Identifies strengths and weaknesses
✔️ Helps with budgeting and forecasting
✔️ Aids investment and credit decisions
⚠️Limitations of Ratio Analysis
✖️Based on historical data – not predictive
✖️ Affected by different accounting practices
✖️ Ignores non-financial elements like employee satisfaction
✖️ A single ratio rarely tells the whole story
🧠Final Thoughts
Ratio analysis is undeniably a must-have in any financial toolkit. It turns dry numbers into useful insights. But like any tool, its value depends on how it’s used.
📌Keep in mind:
- Ratios can be manipulated by clever accounting tweaks
- Numbers don’t always reflect the full story
- Always pair ratio analysis with qualitative assessment and industry comparisons
Used wisely, ratio analysis can guide smarter business, investment, and lending decisions.