Financial ratio analysis is an important tool that is used for detecting a company’s strength and weakness in terms of its finances. Stakeholders often make use of this tool to decide whether they will invest in the company or not. Financial statement of any company contains huge data of the company. The financial analysts are responsible for organizing the data in a compact form and for this, they have to calculate a small amount of financial ratios of the company.
Depending on the analysis perspective, the ratios are of different types. The various groups are liquidity, asset management, profitability, financial leverage, market and divided policy ratio details. The difference in perspective arises due to different objectives of stakeholders. The following part of the article will take you through details of financial ratio analysis and its different types.
For any organization, after the financial statements are prepared, it should be analyzed. Therefore, to check the financial condition of the firm, a tool is required for analysis, and it can be done by ratio analysis. To know better about the company account, the tool can be used by stakeholders. In addition, the stakeholders can grasp a better insight into the current fiscal condition of the business organization. So, by this tool, stakeholders are able to calculate the ratio of accounts of the business. This would give a better understanding of the financial statement of the organization.
What are the Different Types of Financial Ratio Analysis?
Financial ratios can be calculated according to the financial condition of the business. The ratios are compared against other companies and past performance of the company. However, ratio elements such as capital requirements, competition and company risks are compared. So, the financial ratios can be classified into five different categories that are given in the following part of the article.
- Leverage ratio
This ratio is also known as debt management ratio in which two key aspects of the debt of the firm is measured. Therefore, the use of debt financing is known as financial leverage. By knowing about the level of financial leverage of the firm and its ability to deal with debt obligations, this ratio is useful. However, the debt ratio is measured with total debt and total assets. In the case of total equity ratio, long term deposit and total equity are measured.
- Profitability ratio
This ratio is also termed as performance ratios that would help to measure the ability of the firm to earn through profits on assets, equity and sales. These ratios help in determining the rate of investment done in company shares. Some profitability ratios are gross profit margin, operating profit margin, the return rate on assets, net profit margin of assets and return rate on equity of the company.
- Liquidity ratio
With the help of this ration, the firm can meet short-term obligations with assets. The above-said obligations are recorded using current liabilities that of a particular financial year. However, here short term assets are also known as current assets. There are three types of liquidity ratios. They are the current ratio in which current assets and liabilities are measured. Other than this, there is a quick asset ratio, cash ratio. Each of them is measured along with the current liabilities of the company.
- Valuation ratio
This ratio indicates market valuation of stock in terms of company elements such as book value, cash flow, dividends and earnings. These ratios are usually analyzed by investors, and the ratio varies depending on the price of the stock.
- Price / Book value ratio
This valuation ratio is analyzed and watched on a daily basis. From this, you get to know about the market price of a firm share in terms of the book value of the equity. The calculation is done by the market price per share with book value per shares. Also, for book value, both equity and the number of shares are calculated.
- Price / earnings ratio
Among the valuation ratios, this is an important one for any firm. Through this, you get to know the market price of a share in terms of earnings. Here, the market price on every share is calculated with earning per share.
- Price / cash flow ratio
This ratio indicates the price of any company shares in terms of the above-said ratio. The market price per share is calculated with cash flow per share. The price of a share can be related to cash flow that a company is able to generate to shareholders. However, for the shareholders, the cash flow can be considered as the net income of the firm. So, for calculating the total cash flow of the firm, the net income should be included with any depreciation and amortization of the firm.
- Dividend Yield
This refers to the dividend income of the firm, which is a percentage of the total investment made in the firm. It is calculated as the common dividend for every share by the market price of shares. This valuation is important for investors who wish to get regular income from any firm.
- Asset management ratio
The asset management ratios are called as efficiency ratios that depend on the use of assets according to sales generation in the company. Some important efficiency ratios are the average collection span, fixed assets, total assets turnover, inventory turnover.
The Final Part:
Ratio analysis makes financial investment an easy affair, including operating decisions of the firm. In addition, the ratio also simplifies accounting statements into ratios that are easy to calculate. Therefore, by interpreting the financial statement of the company, it becomes easy to maintain the easy cash flow of the firm. Also, a proper financial statement is important for stakeholders.
Therefore, this helps in maintaining the stable financial strength of the firm. In this way, investors would get to know about the financial condition of the firm better. With accurate ratio analysis, it becomes easy to find problem areas of the firm and try to resolve the issues at the earliest by the help of the management. By maintaining financial ratio analysis, the firm is able to compare its financial condition with industry standards, other firms and help in better understanding of the fiscal condition of the overall economy.