**What is Financial Ratio Analysis, and how does it work?**

Financial ratio analysis, as the name implies, is the examination of significant corporate ratios that aid in the detection of a firm’s strengths and shortcomings. Financial ratios and their analysis are used by stakeholders to make key choices about a company’s investments.

Distinct ratio analysis formulas exist, and they are divided into different categories based on the analytical perspective. Financial ratio analysis and interpretation may be used to assess the financial situation of any company.

**Ratio of Financial Leverage**

The financial leverage ratio indicates how much of an asset’s value is backed up by equity. For financial leverage ratio analysis, the formula is average total asset/average total equity. So, if a company’s average total asset is $100 and its average total equity is $50, the company’s financial leverage ratio is 2 (100/50).

It means that for every unit of stock, the corporation can sustain two units of asset. The greater the number, the more powerful the firm is.

**Financial Ratio Analysis’ Importance**

Let’s take a look at the relevance of financial ratio definition analysis now that you know what it is. You may do the following with the aid of financial ratio analysis:

**Recognize a company’s profitability.**

Financial ratios that measure profitability are used to determine how lucrative a company is. You can determine a company’s capacity to create earnings by using this ratio analysis. To put it another way, you may use this ratio to determine how well a firm manages its investors’ funds.

**Examine a company’s operational efficiency.**

You can determine a company’s efficiency using financial ratios like account receivables turnover, fixed asset turnover, and inventory turnover ratio. These ratios can be used to compare two distinct industries within the same area to determine whether firm is better managed than the other.

**Learn about a company’s liquidity.**

Liquidity refers to a company’s ability to meet its short-term obligations. Liquidity financial measures, such as the current ratio, quick ratio, and cash ratio, among others, may be used to identify whether a firm is able to satisfy outstanding costs, such as salaries, taxes, and other obligations.

**Assist in identifying a company’s business risk.**

Another benefit of ratio analysis is this. You can figure out how sensitive the company’s profitability is to its debt outstanding and fixed cost deployment by looking at financial and operating leverage.

Apart from that, financial ratio analysis aids in detecting a company’s financial dangers and determining its future possibilities.

**Also Read: Fundamental Analysis In Stock Market? – Pro & Cons**

**What are the most Important ratios?**

**Price multiples**are used to determine if a company’s stock is reasonably valued in comparison to its competitors.**Profitability ratios**are used to calculate a company’s profit margins.**Liquidity ratios**are used to calculate a company’s working capital condition. These are used to determine whether or not a firm has sufficient liquidity to fund its short-term operations.**Efficiency ratios**are used to calculate a company’s operational efficiency.- The capacity of a corporation to satisfy its debt commitments is measured using
**risk (coverage) ratios**. They also indicate whether or not a corporation can pay dividends.

The stock price of a corporation is divided by an essential item on its income statement or balance sheet to produce financial ratios in this category. If you acquire the shares, they will tell you how much each rupee of the financial statement item will cost you implicitly.** Multiples in price**

You should choose equities with smaller price multiples since you want to spend as little as feasible. Undervalued stocks are what they’re called.

Many financial statement components, including as sales, cash flows, and total assets, are used to compute price multiples. However, profits (i.e. net income) and book value are the most often utilised metrics.

**P/E (price-to-earnings) ratio**

Divide the stock price by the earnings per share to arrive at this figure (EPS). The earnings per share (EPS) is derived by dividing net income by the total number of shares outstanding. The P/E ratio calculates how much it would cost to acquire Re 1 of a company’s net income. Choose equities with the lowest P/E ratio since you will be paying the least for each dollar of profits.

**Price-to-book value (PB)**

Due to frequent fluctuations in the value of income statement components, P/E and other multiples derived using them can be volatile. You can get around this problem by using a price multiple based on a balance sheet metric, such as book value of equity. The total worth of a company’s equity as reported on the balance sheet is called book value. The face value of its shares, retained earnings, certain reserves, and comprehensive incomes that bypass the income statement and go straight to the balance sheet are all included. Book value is transformed to a per share form by dividing it by the number of outstanding shares, just like EPS.

**Also Read:- ****Fundamental Analysis In Stock Market? – Pro & Cons**

**Ratios of profitability**

These financial ratios determine a company’s profitability using multiple profit definitions such as gross profit, operational profit, net profit, and return on equity. Higher profitability ratios are preferable since they indicate a robust and stable firm. The following are some of the ratios:

- Gross profit margin is gross profit divided by sales.
- Operating profit margin is calculated as follows: Operating profit / Sales.
- Net profit margin is net profit divided by sales.
- Net profit divided by the average value of stock is return on equity (ROE).

**Ratios of liquidity**

A company’s short-term liabilities should be matched with current assets, and its long-term liabilities should be matched with fixed assets, according to accounting rules. Its current assets should about equal its current obligations for this.

The ratio of a company’s current assets to its current liabilities is calculated using liquidity ratios. The following are some of the most widely used liquidity ratios:

- The current ratio is equal to the sum of current assets and current liabilities.
- (cash + short-term investments + accounts receivable)/ current liabilities is the quick ratio.
- (cash + short-term investments) / current liabilities is the cash ratio.

The current ratio analyses all current liabilities to all current assets, whereas the quick ratio and cash ratio simply look at the current assets that can be converted to cash the fastest.

The most rigorous measure is the cash ratio, which compares current obligations to solely cash and short-term investments.

Accounts receivable, or the amount owed to a firm by its clients, is also taken into consideration in the quick ratio.

Liquidity ratios should ideally be close to 1, indicating that the firm only has enough short-term assets to cover its current liabilities.

A number of less than one indicates that the company’s current assets are insufficient to cover its liabilities and repay its short-term debt.

If the value is larger than one, the corporation has extra capital in current assets. It may be able to release part of this and use it to fund the company’s expansion.

**Ratios of efficiency (activity)**

This determines how efficient a company’s operations are. The time it takes a corporation to turn its inventory into sales and reimburse its suppliers with the earnings is referred to as operating efficiency.

The cash conversion cycle encompasses the full process of turning inventories to sales and paying suppliers.

Companies with short cash conversion cycles may complete more cycles in a year, therefore operating efficiency is vital. As a result, revenue increases. Companies can obtain income sooner and avoid borrowing money for operational expenditures by efficiently converting inventories to sales.

If you go with the first option, you’ll need to figure out the following:

- Inventory turnover equals the cost of items sold divided by the average inventory*.
- Sales revenue divided by average accounts receivable* is receivables turnover.
- (Cost of goods sold + starting inventory balance – closing inventory balance)/ average accounts payable* = payables turnover

The efficiency of the cash conversion cycle is calculated using these ratios at various phases.

Inventory turnover, for example, calculates the efficiency of converting inventory to sales. A high value for these ratios indicates that they are more efficient. The quantities in the formulae can be directly selected from the income statement or balance sheet. ‘Average’ refers to the year’s average of these components’ beginning and ending values.

The duration of a company’s cash conversion cycle or the number of cycles it completes in a year can be used to assess operating efficiency.

The second way entails figuring out how long it takes the organisation to complete each phase of the cash conversion cycle. For this, the following formulae are used:

**Days of inventory on hand (DOH)**= 365/ inventory turnover ratio**Days of sales outstanding (DSO)**= 365/ receivables turnover ratio**Number of days of payables (DOP)**= 365/ payables turnover ratio

Except for DOP, a low figure for all ratios implies good process efficiency.

Finally, you’ll need to figure out how many days it took to complete the full cycle. For this, use the following formula:

**Cash conversion cycle**: DOH + DSO – DOP

The companies with the most efficient procedures finish the cash conversion cycle in the shortest amount of time.

**Also Read:- How To Read Profit And Loss Statement Of A Company**

**Ratios of risk**

There are two types of money available to businesses: equity and debt. Shareholders’ equity is represented by their investments, whereas debt is represented by bank loans. Because excessive debt raises the likelihood of default, shareholders keep a tight eye on a company’s debt.

It also means that the corporation will have to pay a high rate of interest, reducing dividends and retained earnings.

Risk ratios analyse a company’s capacity to meet its debt commitments by calculating the proportion of debt in its capital structure. Three key financial ratios are included in this category:

- Total debt divided by (total equity + total debt) equals debt to total capital.
- Total debt divided by total equity is the debt-to-equity ratio.
- EBIT/interest expenditure for the period = interest coverage ratio

The debt-to-total-capital and debt-to-equity ratios are used to determine the level of a company’s debt. These ratios with high values suggest a significant level of risk for investors.

The interest coverage ratio is a calculation that determines a company’s capacity to repay its debt. A high interest coverage ratio indicates that a company’s earnings before interest and taxes are sufficient to service its debt.

**Also Read:- How To Read Balance Sheet Of A Company ?**

**The bottom line**

Financial statements merely provide data that is useless unless carefully analysed. A qualitative study of financial data utilising important financial ratios is a fantastic approach to quickly analyse financial data and develop meaningful conclusions. It can assist you in uncovering information that influences stock prices and that, at times, even the firm is unaware of.