Ratio Analysis Formulas

You want to bake a cake, but you don’t know how to check out the recipes for 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 them almost every day in our life. Therefore, in mathematics, ratios are used to compare two or more 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 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 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:

1. Liquidity Ratios

2. Profitability Ratio 

3. Activity Ratio

4. Solvency Ratio

Liquidity Ratios

Liquidity means readily available cash. It is a feature with which anyone can convert assets or security into cash without any effect on 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. 

1. Current Ratio: It gives us the idea of the short-term solvency of a firm.

2. Quick Ratio: It assists us in finding the solvency for six months. 

Here are the Essential Formulas for Liquidity Ratio

Profitability Ratio

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.

Important Formulas of these Ratios

Activity Ratio

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. 

1. 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. 

2. 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.

Solvency Ratio 

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.

1. 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

2. Propriety Ratio: Evaluate the firmness of the capital structure of a business. The formula can be written as:

Propriety Ratio = Stakeholders Equity / Total assets x 100

Few Limitations of Ratio Analysis

Ratio Analysis is very useful for deriving the required information financially, however, it comes with its own set of limitations. Below are listed a few of the disadvantages of Ratio analysis–

1. HIstorical data or inadequate data can cause misinterpretation of ratio analysis.

2. Predictions on the future that depends on past trends may not always be reliable and correct, 

3.  The analyst has to be well versed with the process in order to use ratio analysis.

4. It may not always present an accurate picture since the data used is historical data.  

5. Ratio analysis can not be used in the case of comparison of different companies since every company has a different accounting practice with a different environment. 

Points to Remember About Ratio Analysis

A quick overview of Ratio Analysis is listed below for a better understanding of the chapter. 

1. Ratio Analysis is used for comparing the financial statements of several companies. It can be a useful source for external analysts. 

2. Ratio analysis simplifies and summarizes the information on financial statements. 

3. Analysts can get an idea regarding the efficiency of a firm by reading the information on ratio analysis reports.

4. It can also be helpful for understanding past defects and future trends. 

5. Ratio analysis is not of much use for internal management but it is used by the investors and stakeholders. 

6. The skills of an analyst determine the accuracy of a Ratio Analysis report since it does not always represent an accurate picture. 

7. The tool that is used for measuring the financial position of any company is known as Ratio Analysis and it can be used for any size of business. 

8. Analysts should calculate the gross profit ratio, net profit ratio, as well as, operating profit ratio, and return on investment ratio in order to calculate the profitability of a company. 

9. Single ratios such as quick ratio, current ratio can help in determining the liquidity of a business, however, for optimum results in gaining insights into financial statements, the relatable ratio must be combined. 

Quick Tips to Master this Chapter

• Remember the formulas 

The key to solving the sums related to Ratio Analysis is to remember the formulas. The students must note the formulas and then practice the sums accordingly in order to solve the calculations with ease. 

• Solve as many sums as possible 

Lack of practice can cause a student to forget the basic concepts of this topic. Ratio analysis has calculations based on various assets, profits, and liabilities so in order to avoid confusion, a student must practice the sums rigorously.

• Solve textbook questions 

Students must be well acquainted with the questions present in the textbook. It has the simplest questions and gives an overall idea regarding the questions that will be essential for the exams. Solving regularly will build the foundation for learning and memorizing Ratio Analysis. 

• Practice Solved examples

The solved examples based in the textbooks will surely help a student in preparing for harder questions. It helps in clearing the fundamental concepts and reading through the Ratio Analysis. 

• Clear doubts

Ratio Analysis can be tricky and tough at times so it is natural to have many doubts and get stuck here and there in the chapter. Consulting teachers, friends or using online platforms can help tremendously in clearing those blockages and mastering Ratio Analysis like a pro. 

• Solving sample paper and practice papers

Students must solve the sample papers regularly for sharpening their skills in calculating the questions faster. Sample papers give an overall idea regarding the possible questions which will acquaint the student with this chapter and help during the exams. 

• Participate in online classes

Online classes are a great way for securing better knowledge regarding this topic. Ratio analysis is not just important for math but also for finance as a subject so it will be helpful and useful even after school. A student must be willing to learn and broaden their knowledge regarding this topic. 

• Make notes

Note-taking is a great habit and it can be useful for the students to understand not only the topic but also the formulas. Basic concepts require deeper understanding and writing something always helps in registering the knowledge in mind. It can also be useful during quick reads before the exams. 

The sample papers, online classes, and doubt clearing sessions on Ratio Analysis are available on Vedantu’s official website, as well as, mobile application. The solutions can be downloaded from the website as well. It will surely help the students during the examination season.