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Ratio analysis provides a quantitative financial status of a company in terms of liquidity, solvency, profitability, efficiency, and coverage ratio.

The accounts and amounts for every ratio are formulated from the company’s financial statements.

The significance of calculating these ratios is to acquire relative information about its economic standing, financial performance, the ability to pay short-term and long-term debts, and a comparison tool to its competitors.

The top 5 ratio analysis include Profitability Ratios, Solvency Ratios, Liquidity Ratios, Turnover Ratios, and Earning Ratios.

Top 5 Types of Ratio Analysis

Profitability Ratio

This ratio provides the analysis of profits generated from a company’s capital investment.

Gross Profit Ratio

It measures the company’s operational efficiency after subtracting the cost of goods sold from its generated net sales and then dividing the gross profit by net sales.

Achieving a high gross profit ratio indicates positive cost management and effective planning operational strategy.

The formula for the Gross Profit ratio is:

Gross Profit Ratio = (Gross Profit / Net Sales) *100

Net Profit Ratio

Net Profit Ratio provides the company’s overall operational efficiency after deducting the cost of goods sold and related cash and non-cash operational expenses.

This calculation provides information on the company’s net worth.

It is always favorable to companies whenever they generate a high net profit ratio.

Formula:

Net Profit Ratio = (Net Profit / Net Sales) *100

Operating Profit Ratio

This ratio measures the company’s ability to pay off its debts when they are due.

Formula:

Operating Profit Ratio = (EBIT / Net Sales) *100

Return on Capital Employed

This ratio represents the rate of return of the capital invested.

Formula:

Return on Capital Employed  = EBIT / Capital Employed

Solvency Ratio

The solvency ratio measures the company’s capability to pay off debts.

Debt-Equity Ratio

The Debt-Equity ratio reflects the debts acquired and used in financing the company’s operations.

A lower debt-to-equity ratio signifies less debt financing than equity financing.

The optimal debt-to-equity ratio a company must attain is 2:1.

Formula:

Debt Equity Ratio = Total Debt / Total Shareholders Equity

Where:

Total Debt = Long term debt + Short term debt + Other fixed payments shareholder funds

Total Shareholders Equity =  Equity share capital + Reserves + Preference share capital – Fictitious assets

Interest Coverage Ratio

Some importance of this ratio is:

• Provides financial information on the number of times a company’s profit can facilitate paying off related expenses, and;
• It provides the company’s solvency, which is its ability to pay off debts, and the return of the shareholders’ invested capital.

Formula:

Interest Coverage Ratio = EBIT / Interest Expense

Liquidity Ratios

This ratio represents the company’s ability to pay its short-term obligations with its available cash or highly liquid assets.

Current Ratio

This type of ratio deals with the company’s ability to settle obligations that are due within a year.

It measures the efficiency of its current assets to pay current obligations. A high current ratio means that the company has a large amount of accounts receivables.

The risk of having a high receivable rate is the risk of the receivables being uncollected in the future.

Formula:

Current Ratio = Current Assets / Current Liabilities

Quick Ratio

The time consideration of paying off the company’s liabilities is shorter than the current ratio computation.

It removes inventories from the formula since it might take longer for companies to sell it.

The Quick Ratio Formula:

Quick Ratio = Cash & Cash Equivalents + Marketable Securities + Accounts Receivable / Current Liabilities

Turnover Ratios

To measure the efficiency of the assets and liabilities to generate profit, Turnover Ratios are used.

Fixed Assets Turnover Ratio

This ratio measures the ability of a company’s assets to be an income-generating tool.

They are also described as returns on investment from the company’s fixed assets.

The Fixed Asset Turnover Ratio Formula:

Fixed Assets Turnover Ratio = Net Sales / Average Fixed Assets

Where:

• Net Sales = Gross Sales – Sales Returns and Allowances
• Net Fixed Assets = Gross Fixed Assets – Accumulated Depreciation.
• Average Net Fixed Assets = (Opening Balance of Net Fixed Assets + Closing Balance of Net Fixed Assets) / 2

Inventory Turnover Ratio

The Inventory Turnover Ratio measures the conversion period of the merchandise inventory until it is sold and converted into cash.

This calculation provides information on the average days the merchandise stays at the storage facility before being converted into sales.

It must be noted that the inventory to use is the average inventory due to the fluctuating behavior of the merchandise inventories in one accounting period.

Formula:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories

Receivable Turnover Ratio

The Receivable Turnover Ratio describes the collection efficiency of the company of its accounts receivables.

It calculates how many times a company can collect and convert its receivable into cash within an accounting period.

Formula:

Receivables Turnover Ratio = Net Credit Sales / Average Receivables

Earnings Ratios

This ratio calculates the rate of return for every investment made.

P/E Ratio

Price to Earnings ratio or P/E ratio measures the company’s overall value through stock price over its price earnings per share.

Having a high P/E ratio means the company’s shares have a high market valuation.

Formula:

P/E Ratio = Market Price per Share / Earnings Per Share

Earnings Per Share (EPS)

The Earnings Per Share (EPS) is the amount a shareholder earns in a current market for every share invested in a company.

Formula:

Earnings Per Share  = (Net Income – Preferred Dividends) / (Weighted Average of Shares Outstanding)

Return on Net Worth

Return on net worth is the amount of money an investor earns from the equity investment.

Formula:

Return on Net Worth = Net Profit / Equity Shareholder Funds

Where:

Equity Funds = Equity + Preference + Reserves – Fictitious Assets

Conclusion

The different types of ratios explained above are the most used financial ratio analysis in a company.

The companies use these ratios in their strategic management planning.

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1. Massachusetts Institute of Technology "Ratio Analysis" Page 1 - 10. December 1, 2022

2. Duke "Summary of Financial Ratio Calculations " Page 1 - 5. December 1, 2022