THEORETICAL PERSPECTIVE

RATIO ANALYSIS & TYPES

Ratio analysis is a quantitative method that helps ascertain a company’s profitability,

liquidity, and operational efficiency. It is the main tool in fundamental analysis. Ratio
analysis helps in analysing the financial health of a company.

Financial ratios are organized into four categories:

o Profitability ratios
o Liquidity ratios
o Solvency ratios
o Valuation ratios

PROFITABILITY RATIO

Profitability ratios are a class of financial metrics that are used to assess a business's
ability to generate earnings relative to its revenue, operating costs, balance sheet
assets, or shareholders' equity over time, using data from a specific point in time.
They are among the most popular metrics used in financial analysis.

Profitability ratios can be a window into the financial performance and health of a
business. Ratios are best used as comparison tools rather than as metrics in isolation.

Profitability ratios can be used along with efficiency ratios, which consider how well
a company uses its assets internally to generate income (as opposed to after-cost
profits).

A company's profitability ratios are most useful when compared to those of similar
companies, the company's own performance history, or average ratios for the
company's industry. Normally, a higher value relative to previous value indicates that
the company is doing well.
Gross Margin Ratio:

Gross profit margin, also known as gross margin, is one of the most widely used
profitability ratios. Gross profit is the difference between sales revenue and the costs
related to the products sold, the aforementioned COGS. Gross margin compares
gross profit to revenue. It measures the percentage of each sale in rupees remaining
after payment for the goods sold.

For example, retailers typically experience significantly higher revenues and

earnings during the year-end holiday season. Thus, it would be most informative and
useful to compare a retailer's fourth-quarter profit margin with its (or its peers')
fourth-quarter profit margin from the previous year.

Interpretation-Gross profit margin depends on the relationship between sales price,

volume and costs. A high Gross Profit Margin is a favourable sign of good
management.

Gross Margin Ratio = (Revenue – COGS) / Revenue

Return on Assets:

The profitability ratio is measured in terms of relationship between net profits and
assets employed to earn that profit. This ratio measures the profitability of the firm in
terms of assets employed in the firm. Based on various concepts of net profit (return)
and assets, the ROA may be measured as follows:

ROA= NET PROFIT AFTER TAXES / AVERAGE TOTAL ASSETS

OR

ROA= NET PROFIT AFTER TAXES / AVERAGE TANGIBLE ASSETS

OR

ROA= NET PROFIT AFTER TAXES / AVERAGE FIXED ASSETS

Liquidity Ratios.

The terms 'liquidity' and 'short-term solvency' are used synonymously.

A Liquidity Ratio measures a company’s ability to cover its short-term obligations

using its “most liquid” assets (i.e., the assets that are easiest to turn into cash
quickly). There are several types of liquidity ratios, and each includes different
components of a company’s assets and liabilities.

Liquidity of short-term solvency means ability of the business to pay its short-term
liabilities. Inability to pay-off short-term liabilities affects its credibility as well as its
credit rating. Continuous default on the part of the business leads to commercial
bankruptcy.

Eventually such commercial bankruptcy may lead to its sickness and dissolution.
Short-term lenders and creditors of a business are very much interested to know its
state of liquidity because of their financial stake. Both lack of sufficient liquidity and
excess liquidity is bad for the organization.

In corporate finance, people often focus on a company’s growth rates, profit margins,
and valuation – but liquidity ratios can also be extremely useful in certain contexts,
especially when you analyze a company from the perspective of lenders and
suppliers. Effectively, liquidity ratios indicate the company’s ability to pay off its
short-term obligations as they come due, and they give you insight into how much
“downside risk” the company has.

For example, if the economy enters a recession, and the company’s Cash balance
starts declining, or it has trouble collecting Cash from customers, how much trouble
is it in? Could it still meet its obligations for a year?

Or would have it to raise additional capital or sell assets to survive over the next
year?

Since lenders and other debt investors focus very heavily on the downside case,
liquidity ratios are critical for them – even if the average investment banker or
valuation specialist doesn’t spend much time on them.
Following are the few types of liquidity ratios:

The Current Ratio:

The Current Ratio is one of the best known measures of short-term solvency. It is the
most common measure of short-term liquidity.

The main question this ratio addresses is: "Does your business have enough current
assets to meet the payment schedule of its current debts with a margin of safety for
possible losses in current assets?" In other words, current ratio measures whether a
firm has enough resources to meet its current obligations.

Current Ratio = Current Assets / Current Liabilities

Interpretation- A generally acceptable current ratio is 2:1. But whether or not a

specific ratio is satisfactory depends on the nature of the business and the
characteristics of its current assets and liabilities.

The Quick Ratio/ Acid-test Ratio: The Quick Ratio is a much more conservative
measure of short-term liquidity than the Current Ratio. It helps answer the question:
"If all sales revenues should disappear, could my business meet its current
obligations with the readily convertible quick funds on hand?"

Quick Assets consist of only cash and near cash assets. Inventories are deducted from
current assets on the belief that these are not 'near cash assets' and also because in
times of financial difficulty, inventory may be saleable only at liquidation value. But
in a seller's market, inventories are also near cash assets.

Cash & cash equivalents + Market securities + Accounts receivables/ Current

Liabilities

Interpretation-An acid-test of 1:1 is considered satisfactory unless the majority of

"quick assets" are in accounts receivable, and the pattern of accounts receivable
collection lags behind the schedule for paying current liabilities.
Solvency Ratios

Solvency is an important indicator of a company's long-term financial health.

Measuring solvency ratios gives professionals insight into how efficiently companies
pay off debt and interest and use assets to fund operations.If you're interested in
developing cost-reduction strategies and achieving profitable outcomes, it might be
helpful to learn more about solvency ratios and how to measure them.

A solvency ratio is a financial metric that measures a company's ability to cover

long-term liabilities and shows how efficiently it generates cash flow to meet future
debt obligations. Solvency ratios indicate the financial health of a business and help
investors, managers and shareholders better evaluate profitability.

Solvency ratios incorporate several different factors and are often part of a larger
analysis that determines whether businesses can remain profitable over time.

The first factor is actual cash flow rather than net income. When measuring this,
companies account for depreciation and expenses to understand financial capacity.
When measuring solvency, professionals also consider all debt obligations instead of
only a company's short-term liabilities.

The Solvency ratios may be defined as those financial ratios which measure the long-
term stability and capital structure of the firm. These ratios indicate the mix of funds
provided by owners and lenders and assure the lenders of the long-term funds with
regard to:

 Periodic payment of interest during the period of the loan and

 Repayment of principal amount on maturity

The main solvency ratios are the debt-to-assets ratio, the interest coverage ratio, the
equity ratio, and the debt-to-equity (D/E) ratio. These measures may be compared
with liquidity ratios, which consider a firm's ability to meet short-term obligations
rather than medium- to long-term ones.
Types of Solvency Ratios

Equity Ratio: The shareholder's equity is Equity share capital and Reserves &
Surplus (excluding fictitious assets etc). Net Assets or Capital employed includes Net
Fixed Assets and Net Current Assets (Current Assets - Current Liabilities).

The equity ratio is a financial metric that measures the amount of leverage used by a
company. It uses investments in assets and the amount of equity to determine how
well a company manages its debts and funds its asset requirements.

A low equity ratio means that the company primarily used debt to acquire assets,
which is widely viewed as an indication of greater financial risk. Equity ratios with
higher value generally indicate that a company’s effectively funded its asset
requirements with a minimal amount of debt

Shareholder Equity Ratio = Total Shareholder Equity/ Total Assets

This ratio indicates proportion of owner's fund to total fund invested in the business.
Traditionally, it is believed that higher the proportion of owner's fund, lower is the
degree of risk for potential lenders.

Debt-to-Equity (D/E) Ratio: The debt-to-equity ratio (D/E) compares a company’s

total debt balance to the total shareholders’ equity account, which shows the
percentage of financing contributed by creditors as compared to that of equity
investors.

Higher D/E ratios mean a company relies more heavily on debt financing as opposed
to equity financing – and therefore, creditors have a more substantial claim on the
company’s assets if it were to be hypothetically liquidated.

A D/E ratio of 1.0x means that investors (equity) and creditors (debt) have an equal
stake in the company (i.e. the assets on its balance sheet). Lower D/E ratios imply the
company is more financially stable with less exposure to solvency risk.

D/E Ratio = Total Liabilities/ Total Shareholder’s Equity

Valuation Ratios:

Valuation ratio is conducted to decide whether the stock of a company is currently

selling at attractive (cheap/undervalued), fair (rightly priced) or expensive
(overvalued) valuations. It is done post-financial analysis, to select stocks for further
analysis.

Once an investor has found a financially strong company by using the parameters
highlighted in the financial analysis guide, she should do the valuation analysis to
check whether the stock of the company is priced right.

If the shares of a company are overvalued then the investor should avoid investing in
it, however good the company's financial position may be. Investing hard-earned
money in overvalued stocks exposes the investor to higher levels of risk where the
potential of future appreciation is limited but the risk of loss of money is high.
Therefore, valuation analysis becomes paramount before taking a decision to buy any
stock.

Valuation analysis compares the stock market values of the stock of a company with
its financial parameters. Stock market values consist of the current market price
(CMP), market capitalization (MCap) etc.

The asset-based method is typically performed by creditors or in special situations

like liquidation. The income-based approach is superior but burdensome and prone to
uncertainty. Therefore, using comparable ratios (or the market-based approach) is
often preferred as a quick and straightforward method of valuation analysis.

Common equity multiples include price-to-earnings (P/E) ratio, price-earnings to

growth (PEG) ratio, price-to-book ratio (P/B), and price-to-sales (P/S) ratio.
Types of Valuation ratios are as followed;

Earnings per Share (EPS):

One of the most commonly used per-share stock valuation ratios is earnings per
share (EPS). It divides a company’s net income by the number of outstanding shares:

Earnings per share (EPS)= Net income−Preferred dividends / Outstanding number of

common shares

The EPS tells us how much income a company earns per common share. This is a
valuable measure because, over the long term, net profit is the primary determinant of
investment value. But EPS tends to be unstable yearly, so sometimes analysts take
the normalized EPS adjustments of an average of five or even ten years.

Price-to-Earnings (P/E) Ratio:

The price earnings ratio indicates the expectation of equity investors about the
earnings of the firm. It relates earnings to market price and is generally taken as a
summary measure of growth potential of an investment, risk characteristics,
shareholders orientation, corporate image and degree of liquidity. It is calculated as

Price-Earnings per Share (P/E Ratio) = Market Price per Share (MPS) / Earning per
Share (EPS)

Interpretation- It indicates the payback period to the investors or prospective

investors. A higher P/E ratio could either mean that a company's stock is over-valued
or the investors are expecting high growth rates in future.

The advantages of using P/E ratios for the valuation of a company are that it’s easy to
obtain and considers the investment value’s primary driver: earnings. Its
disadvantages stem from the fact that earnings are often volatile, can be manipulated,
and even in the negative. In addition, the P/E ratio (like other price multiples) does
not consider the company’s debt burden.
Advantages Of Ratio Analysis

Ratio analysis is a powerful tool employed by enterprises and financiers to scrutinise

the monetary well-being of a corporation. Companies can gain insights into their
financial performance, profitability, and liquidity by analysing various financial
ratios. In this part of the article, we will discuss the advantages of ratio analysis.

Efficiency- Inventory turnover and sales turnover ratios demonstrate. Firm efficiency
in utilizing its resources to generate sales or utilize inventory. A high ratio indicates
good efficiency. While a decreasing ratio may indicate a buildup of inventory,
outdated products, or ineffective marketing.

Solvency- These numbers tell us if a firm has enough aids to pay its bills now and
later. Big firms like S&P and Moody's check these numbers to decide if investing in a
firm is safe. We look at other numbers. Like how much money the firm has and how
fast they can access it if needed.

Liquidity- The liquidity ratio is how much money a firm has in cash and near-cash
things. It helps to see if the firm can get money fast for something unexpected. But if
a firm has too much money in these things, it might not get more money from other
investments. So, it's best for a firm to have the right amount of liquidity.

Market Performance- Ratios like P/E ratio, P/Sales ratio, P/BV ratio, EV/EBITDA
help us know if a firm is worth more or less than similar firms. They also help
investors decide if they should buy the stock based on the level of risk. Management
can also use these ratios to apprehend how the firm's performance affects the share
price and decide on future plans.

Profitability- Ratios like Gross Profit Margin, Net Profit Margin, Return on Equity
help understand if investing in a firm is good or not. If Net Profit Margin is low and
Gross Profit Margin is high, it means the firm spends a lot and needs to fix this.
Planning- When the people in charge see the numbers, they can make plans for what
to do next. They might decide to spend money on growing their firm or think about
renting instead of buying things. They also think about what might happen in the
future and make a plan for how to make the firm bigger over time.+

Budgeting- When a store sells things quickly, it's good for them. They can order a lot
at once and save money. This is because they won't need to order again for a while.
It's like buying in bulk. It's the same for other expenses like paying for rent or
electricity. The store can plan how much they need to spend. According to how much
they sell. This helps them make sure they have enough money.

Disadvantages Of Ratio Analysis

Although ratio analysis has several advantages, it is crucial to acknowledge that its
use presents limitations and potential drawbacks. In this part of the article, we will
discuss the disadvantages of ratio analysis.

Limited scope- Ratio analysis focuses exclusively on financial ratios and does not
consider non-financial elements. For example, a firm with high financial ratios may
still struggle with customer satisfaction, employee morale, and brand image. Hence, a
comprehensive assessment of a firm's overall health requires considering financial
and non-financial variables.

Incomplete comparison- Comparing financial ratios across various industries and

firms may not be equitable, as distinct industries and firms possess unique financial
and operating features. For instance, a favourable high inventory turnover ratio in
retail may not hold for manufacturing. Therefore, careful interpretation of ratios is
required, viewing the specific traits of the industry and the firm under analysis.

Historical data- Ratio analysis relies on historical financial data. Financial ratios are
computed based on previous performances, which may not be a dependable tool for
forecasting future financial trends and performances. Furthermore, a firm's financial
performance can be affected by various external factors, such as alterations in market
conditions, economic factors, or other influences that may not be captured in
historical financial data.

Manipulation- Bookkeeping techniques can manipulate financial metrics, such as

overly optimistic revenue recognition or inflating the value of firm assets. For
instance, a corporation might decrease its inventory levels temporarily at the end of a
quarter to enhance its present ratio. As a result, it is imperative to scrutinise the
financial reports closely to ascertain that the metrics are not artificially augmented.

Inaccurate assumptions- Ratio analysis is based on certain beliefs about the

accuracy of financial statements, the uniformity of accounting procedures, and the
comparability of financial statistics. Nevertheless, these assumptions may not be
invariably valid. The financial statements may contain inaccuracies or exclusions, the
accounting practices may differ among trades and entities, and the financial data may
not be promptly similar because of disparities in reporting protocols or accounting
doctrines.