GMAT / GRE Mathematics Tutorial Series: Ratio Analysis

In order to better analyze a financial statement, ratio analysis formulas can be used to study the information given in the statements. In this article, we will cover the basic definition of ratio analysis, the different types of financial ratios, and a brief account of its limitations.

Introduction to Financial Statement Analysis

A ratio indicates a relationship between two numbers, by expressing one number as a fraction of the other, thereby comparing them.

For example, if you have three pens and two pencils, we can say that the pens and pencils are in the ration of three is to two, or 3: 2. This also implies that for every three pens there are two pencils.

In the financial domain, ratios give an insight into the performance of companies. This will help investors and business managers to evaluate the growth and understand the sustainability of their businesses.

Consider the “current ratio” or the “liquidity ratio”. This ratio compares the current assets (assets that can be converted to cash in one year) to the current liabilities (liabilities that have to be cleared within one year) of a company.

If a company’s current ratio is 10:1, or 10, it indicates that its current assets are ten times its current liabilities—that is, the company can pay off its current debts ten times over.

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Uses of Ratio Analysis

GMAT Exam Ratio Analysis Tutorials calculated from the data in financial statements have three main benefits to investors:

  • Easier comprehension of financial statements: Investors can easily analyze the statement using a few ratios to arrive at the required information, eliminating the need to understand the entire statement.
  • Identification of problematic trends: A study of the ratios over a period of time can help the investors identify the main problematic areas in their business. They can also estimate the likely performance of the company in the future.
  • Facilitate comparisons: Using these ratios, a certain company can also evaluate its performance by comparing it with the other companies in the same industry/sector.

For example, two companies in the same sector can be compared on the basis of their current ratios. A company with a current ratio of 5:1 can more easily clear its current debts than a company with a current ratio of 1.5:1.

These ratios can be compared with the general standard current ratio for companies in that particular sector. The current ratio for companies in the manufacturing sector is usually taken to be 2:1 

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Types Of Financial Ratios

In terms of financial statement analysis, the financial ratios can be classified into five main groups: liquidity, solvency, efficiency, profitability, and valuation.
1) Liquidity ratios

Liquidity ratios give an indication of the company’s abilities to meet its short term dues or current liabilities. It not only shows the amount of cash immediately available but also shows the assets that can be immediately converted to cash to meet the company’s obligations.

Examples of Liquidity ratios: Quick ratio also known as acid-test ratio and working capital ratio also known as current ratio

The quick ratio, or the acid-test ratio, gauge the ability of a company to clear its current liabilities using just its “quick assets”. (These are assets that can be converted into cash within a period of 90 days. Short term investments, marketable securities, cash, etc. come under quick assets).

Ratio Analysis Formula for quick ratio: The quick ratio is arrived at by dividing the total current assets with the total current liabilities.

What does it mean to investors? The quick ratio shows the liquidity level of the company. It gives an indication as to how quickly a company can convert its quick assets into cash to clear its current obligations, without using the capital assets of the company.

The working capital ratio, or the current ratio, is a liquidity ratio that measures the capacity of a company to meet its current liabilities using its current assets. (Assets that can be converted into cash within 12 months: for example, cash and cash equivalents).

Ratio Analysis Formula for capital ratio: This ratio is calculated by dividing current assets by current liabilities.

What does it mean to investors? This ratio also referred to as the working capital ratio, indicates whether a firm has sufficient cash to manage its day to day operations. 

2) Solvency ratios

The solvency ratio gives an assessment of the long term financial health of a company, by measuring its abilities to meet the obligations of creditors and sustain the effective operation of the company. It compares a company’s debt levels with its earnings, equity, and assets. 

Example of Solvency ratio: Debt-to-equity ratio.

The debt-to-equity ratio indicates the relative proportion between debts taken by the company to its equity. Using this ratio, one can determine the volume of funds coming from banks and creditors and the volume of funds from shareholders of the company.

The formula for debt-to-equity ratio: This ratio is arrived at by dividing the total liabilities by the total equity.

What does it mean to investors? A low debt-to-equity ratio implies that the company is in good health as the company is financed by its shareholders and other investors rather than by banks and other creditors.

3) Efficiency ratios

Efficiency ratios measure how efficiently a company manages its assets to make profits or convert its inventories into cash. These ratios gauge the time taken by a company to collect cash from its clients for goods/services offered to them on credit.

Simply put, the efficiency ratio highlights how effectively the daily operations of manufacturing and selling are managed in order to make a profit.

Example of Efficiency ratio: Accounts receivable turnover ratio.

The accounts receivable is the payment due to a company from its clients for services rendered on credit. This ratio expresses how effectively a company collects the money owed by its clients for services offered on credit. It also indicates the number of times (turn) this collection happens.

Ratio Analysis Formula: Let’s assume that a company’s average account receivable for a particular year is Rs. 1 crore (the average is calculated by adding the receivables at the beginning and at the end of the year), and it collected Rs. 2 crore during the year, its accounts receivable turnover ratio is Rs. 2 crore divided by Rs. 1 crore, that is, 2.

Accordingly, the company collected its accounts receivable twice a year, or every six months.

 A company that has reported an accounts receivable turnover ratio of 4 has collected its accounts receivable every 90 days or on a quarterly basis.

What does it mean to investors? The higher the accounts receivable turnover ratio, the greater its efficiency as it indicates that the company collects its receivables quite frequently.
 

4) Profitability ratios

Profitability ratios showcase a company’s abilities in effectively utilizing its assets to make profits.

Example of Profitability Ratio: Return-on-assets ratio.

The return-on-assets ratio shows the total net income of a company in relation to the overall investments during a period. This is an important index, as it involves capital assets, which is often the largest investment for most businesses.

Ratio Analysis Formula: This ratio is calculated by dividing the net income by the average total assets (the total assets at the beginning and end of the year divided by two).

What does it mean to investors? A high return-on-assets ratio indicates that the assets are utilized optimally; a low ratio, on the other hand, indicates that the investment in assets is higher than what is required or that the company is not able to utilize its assets to its maximum to gain profits.
 

5) Valuation ratios

Valuation ratios help investors assess the value of company stock and decide on whether to buy, hold, or sell its shares. These ratios also enable them to predict the future of the stock and the returns to expect.

Example of Valuation Ratio: Price-earnings ratio.

The price-earnings (PE) ratio is a valuation ratio that shows the relationship between the price paid for a share and the earnings gained from the share. This ratio reveals the stock market’s assessment of the value of a share of a company based on the share earnings declared.

The formula for Price-earnings ratio: The ratio is arrived at by dividing the current market value price for a share by earnings per share, and is generally calculated at the end of a financial year.

What does it mean to investors? The PE ratio gives the expected price of a share based on its earnings. Based on this ratio, a prospective buyer can arrive at a conclusion on the earnings that can be expected, which either can be in the form of higher dividends or higher share prices when the share is sold.

Companies within the same industry can be compared with each other on the basis of the PE ratio. However, this ratio can be manipulated by management. An extremely high ratio, for example, could mean that profits have probably been overstated and can indicate an impending fall in share price.

Therefore the financial ratios help gain meaningful information about the company in terms of its performance based on different parameters. Ratio analysis allows the investors to study the sustainability and future of their investments.

For instance, certain figures may show that a company is profitable, but the applicable financial ratios may point to issues in cash flows. Financial ratios can also signal managers about the areas that needs complete focus and attention.

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Limitations of Ratio Analysis

Though financial ratios and ratio analysis have several advantages, there are added disadvantages as well:

  • As the data used for the calculation of financial ratios and ratio analysis are past results (historical data), the information gained is not current/up-to-date.
  • Since the calculation of financial ratios are based on various estimates, the information arrived at from the ratio analysis may not be accurate.
  • Financial ratios and ratio analysis may not be a suitable tool to compare companies from different sectors as the economic environment of each company may be different.

In fact, it may not be suitable to even compare companies within the sector as they may be following different accounting practices and operational policies.

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