What are Ratios?
You want to bake a cake, but you don’t know how to check out the recipes of cake so. The method says that you have to mix flour and water in the ratio of 2:1. What does it mean? It means that if you are taking 2 cups of flour to bake a cake, you will have to add 1 cup of sugar in it. This representation of 2 cups of flour and 1 cup of water is done in the form of a ratio. We use ratios or see examples of it almost every day in our life. Therefore, in mathematics, ratios are used to compare two or more than two quantities that have the same units to represent a fraction.
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What is Ratio Analysis?
Ratio analysis is an essential tool for a quick indication of a business’s financial health in various key areas. It determines and interprets the relationships between the items of financial statements. Its objective is to offer a meaningful understanding of the performance and financial position of an enterprise. Thus, it is a method that analyzes financial statements by using ratio analysis formulas. It provides information about the cash flows of an organization; thus the accounts and the all financial ratios formulas of business are created with careful accuracy that showcases the genuine picture of the working of the company. Once the preparation for the financial statement is done, various tools are required to analyze it. One of them is the Ratio analysis formulas. It is a quantitative tool that is used to assess all financial ratios formulas of the business. Ratio analysis formulas help to update about the company’s liquidity, operational efficiency, and profitability by studying all financial ratios formulas.
Types of Ratio Analysis
There are four types of ratio analysis
Liquidity means the readily available cash. It is a feature with which anyone can convert assets or security into cash without any effect in the market price. Any person or a firm can buy or sell an asset without any drastic change in the asset’s price. Therefore liquidity ratio uses ratio analysis equations to help us to determine the short term liquidity of a firm. There are two types of liquidity ratios.
Current Ratio: It gives us the idea of the short term solvency of a firm.
Quick Ratio: It assists us in finding the solvency for six months.
This is the area where the actual business takes place. The profitability ratio is the one that finds out if the business being done fetches any profit or not. It measures the success of the business effectively over some time. The main profiteers of these ratios are the government, the tax holders, the stakeholders, and business owners. We all need a bank loan but we don’t know that before granting us the loan, the bank officials check the profitability status with the help of these ratios. Another key feature of profitability ratio analysis equations is that it judges the company based on its ability to generate profit.
We can call it by another name i.e., turnover ratio. It is used for the estimation of the efficiency of the firm and for converting the product into cash. The activity ratio works on the basis of the duration of the days. It is of two types.
Inventory turnover ratio: updates on the frequency of the conversion from product to cash. The formula is written as:
Inventory Turnover Ratio = cost of goods sold/ average inventory.
Receivable turnover ratio: updates on the frequency of the collection of credits. The formula can be written as:
Receivable Turnover Ratio = Net credit sales/ average trade receivable.
The solvency ratio checks the validity of the business and its ability to pay the long term debt of a company. Under this, there are two of its kinds.
Debt Equity Ratio: Evaluates the firmness of the long term financial policies of a business. The formula can be written as:
Debt Equity Ratio = Total liabilities/ Stakeholders equity
Propriety Ratio: Evaluates the firmness of the capital structure of a business. The formula can be written as:
Propriety Ratio = Stakeholders Equity / Total assets x 100
Q1. What is the Ratio Analysis Objective?
Ans: Some of the essential objectives of ratio analysis are:
Evaluates the strength and weakness of the business
Assess the liquidity, the solvency, the profitability, and the level of efficiency of the business.
Good at budget preparations
Utilization of assets are properly done
Clear comparison between inter and intra company.
An excellent method to predict the future course of actions of the business.
It helps to review the past trends of the management.
Intelligence, skill, and proper data are the key points in the analysis, interpretation, and calculation of the ratios.
Q2: What is Ratio Analysis Limitation?
Ans: Everything has its advantages and limitations. Just as the ratio analysis has advantages, it has a few limitations parallelly. Some of the limitations are:
Misinterpretation is one of the major limitations in ratio analysis because of inadequate or historical data.
Reviewing past trends management is not always suitable for future prediction; they may also not be correct.
Only the person who is highly skilled and has enormous knowledge can use ration analysis correctly.
Ratio analysis may not offer a realistic picture of the business as the data is dependent on historical data.
A comparison between the company’s performance of different sectors cannot be done using ration analysis as different companies work in a different environment and have different accounting practices.