Ratio analysis is a term widely used in business accounting in comparing different line items in the company’s balance sheet to understand its progress over time. It is used to evaluate various aspects of liquidity, the efficiency of operations, and profitability to understand a company’s financial health. These ratios are particularly useful to outside investors and analysts in forming investment decision.
For the analytical purpose and convenience, investors used different types of ratio analysis in their evaluation process. To be able to use ratio analysis in your trading technique, you need a thorough understanding of the types of ratio analysis.
So, here in this article, we will explain in detail the types of ratios in ratio analysis that will come handy to you.
One of the primary reasons to apply ratio analysis is to identify which stocks are worth investing. It is useful in analysing company’s long-term financial growth, establish a trend, and compute dividend earning from equities and debts.
Types Of Ratio Analysis:
There are a number of categories that are used to group the different types of ratio analysis. This categorisation is based on the nature of the information they provide. Most of them are used by industry outsiders to make projections and identify trends from information provided by a firm’s financial statements.
Liquidity Ratios: This type of ratio assesses an organisation’s ability to deal with short term debt by utilising its current assets. When firms run into times of financial difficulty that prevents them from paying off debts using their revenue, they may liquidate their assets and use the funds generated to fulfil such obligations as and when necessary. These types of ratios in ratio analysis are used by financial lending institutions, suppliers and banks to assess whether an organisation is capable of honouring its financial obligations in time. Some liquidity ratios include quick ratio, cash ratio, working capital ratio, and the current ratio.
Solvency Ratios: These ratios are also referred to as leverage ratios in that they estimate a firm’s ability to manage its financial commitments and conduct business in the long term. This is done by weighing a company’s outstanding debts with interest against parameters such as its equity, assets or earnings to gauge whether they will be able to pay these off in due time while staying profitable. They are often used by governments, banks and investors. Different types of ratio analysis under this category include debt-equity ratios, equity multiplier, and debt-assets ratios.”
Coverage Ratios: Sneha continues“Coverage ratios help in determining a business’ ability to pay off debts and the interest generated by them with higher ratios indicating a higher capability of fulfilling such obligations. These ratios, when analysed over long periods of time, can point towards trends and provide an estimation of the direction in which the company’s financial health will progress. Times interest earned ratio, fixed coverage, interest coverage and the debt-service coverage ratios are examples of this category”.
Efficiency Ratios: Also known as turnover ratios, these types of ratios in ratio analysis are used to judge the degree of efficiency in a company’s handling of its assets, liabilities, equity and inventory in order to generate profits. Improvements in these ratios may indicate that the company is headed towards a period of prosperity. Some important efficiency ratios include asset turnover ratio, inventory turnover, payables turnover, working capital turnover, fixed asset turnover, and receivables turnover ratio.
Profitability Ratios: Profitability ratios evaluate a firm’s ability to generate profits concerning operating costs. Increases in these types of ratios over time are often indicative of improving financial performance. Comparisons of these ratios between similar organisations in the same sector can be used to gauge relative performance against the prevailing economic climate. Profit margin, return on assets, return on equity, return on capital employed, and gross margin ratios are examples of these types of ratio analysis.
Market Prospect Ratios: Finally, market prospect ratios, also known as earnings ratios, are used by investors to estimate earnings on investments. These earnings can come in the form of growing dividends or appreciation of equity value. Dividend yield, earnings per share, the price-to-earnings ratio, and the dividend payout ratio are part of this category and are some of the most commonly used types of ratios in ratio analysis.
To use these ratios, you must learn how these are calculated and applied. We are likely to come up with another article, discussing the topic in detail. Till that time, continue investing with Angel Broking.