Ratio Analysis and Its Purpose
- Ratio analysis is a quantitative tool used to evaluate a business’s financial performance by comparing different financial figures. It involves calculating ratios using data from the balance sheet and income statement.
- Purpose of Ratio Analysis:
- Financial position: Assess liquidity, profitability, and capital structure.
- Financial performance: Evaluate efficiency and expense control.
- Decision-making: Aid investment decisions and strategic planning.
- Types of Ratio Comparisons:
- Historical comparisons: Compare current ratios to past performance.
- Inter-firm comparisons: Compare ratios to industry competitors.
- Key Financial Ratios:
- Profitability Ratios: Measure the ability to generate profit.
- Gross profit margin: Measures the profitability of sales.
- Profit margin: Measures overall profitability.
- Return on capital employed (ROCE): Measures the efficiency of using capital to generate profit.
Profitability Ratio
- The profitability ratios measure the financial performance of a business by comparing profit to other figures like sales revenue or capital employed. These ratios are crucial for profit-oriented businesses and are of interest to managers, employees, and investors.
- Key Profitability Ratios:
- Gross Profit Margin (GPM): Compares gross profit to sales revenue.
- Profit Margin: Compares net profit to sales revenue.
- Return on Capital Employed (ROCE): Compares profit to capital invested.
- Improving profitability ratios:
- Increase sales revenue: Reduce prices for elastic products, raise prices for inelastic products, improve marketing, or seek alternative revenue streams.
- Reduce costs: Cut direct costs (materials, labor) or indirect costs (expenses).
- ROCE analysis:
- ROCE measures how efficiently capital is used to generate profit.
- Higher ROCE indicates better financial performance.
- ROCE should exceed interest rates on bank deposits.
- Improving ROCE involves increasing profit or decreasing capital employed.
- Understanding profitability ratios is essential for businesses to assess their financial health and make informed decisions.
Liquidity Ratio
- Liquidity ratios measure a company’s ability to pay its short-term debts using its current assets. Creditors, investors, and shareholders are interested in these ratios.
- Key liquidity ratios:
- Current ratio: Compares current assets to current liabilities.
- Acid test ratio (quick ratio): Excludes inventory from current assets.
- Ideal ratios:
- Current ratio: Generally between 1.5 and 2.0.
- Acid test ratio: At least 1:1.
- Improving liquidity:
- Increase current assets: Sell inventory, collect receivables.
- Decrease current liabilities: Reduce overdrafts, negotiate with creditors.
Liquidity ratios are essential for assessing a company’s short-term financial health and its ability to meet obligations.
Limitations of Ratio Analysis
- Ratio analysis is a valuable tool but has limitations:
- Historical focus: Ratios reflect past performance, not future trends.
- External factors: Economic changes can affect ratios without underlying changes in performance.
- Lack of standardization: Different accounting practices can make comparisons difficult.
- Qualitative factors: Non-financial factors like employee motivation and social impact are not considered.
- Limited scope: Ratios provide a partial view of a business’s performance.
To effectively assess a business’s performance, it’s essential to consider both financial ratios and other qualitative factors.
