Financial Ratio Analysis: Meaning, Different Types and Need

What is Ratio Analysis?

Ratio analysis is an important tool for expressing relationships among various data points presented in a company's financial statements that can be used for both intra-firm and inter-firm comparisons. 

Precisely, ratios are calculated to do the following:

• Project future earnings and cash flow.
• Evaluate a firm’s flexibility (the ability to grow and meet obligations in adverse situations).

• Judge management’s performance.
• Evaluate changes in the company and industry over time and compare the company with industry competitors.

What is the Need for Ratio Analysis?

Many of us wonder why there is even a need for ratio analysis if we already have data presented in all three financial statements studied before, right? Well, let’s consider an example to understand this better. 

Let’s consider two companies - A Ltd and B Ltd, in the same industry.

Company A	Amount [In ₹]		Company B	Amount [In ₹]
Revenue from operations	50,00,000		Revenue from operations	28,00,000
Net profit	15,00,000		Net profit	10,00,000

As clearly visible, Company A is performing better in revenue and net profit than Company B. However, please note that these are absolute numbers and thus might deceive you. 

By simply looking at the absolute numbers, you cannot compare two firms of different sizes on the basis of efficiency, profitability, etc. This is where ratio analysis comes to the investor's rescue. Let’s compare the above companies using a simple ratio like net profit margin. Simply put, it is the ratio of net profit to revenue from operations. Don’t worry; we will understand this ratio better further in the profitability ratios chapter. 

Let’s calculate the ratio for both of the above companies:

Company A	Amount [In Rs]		Company B	Amount [In Rs]
Revenue from operations	50,00,000		Revenue from operations	28,00,000
Net profit	15,00,000		Net profit	10,00,000
Net Profit Margin = Net profit / Revenue from operations	30%		Net Profit Margin = Net profit / Revenue from operations	36%

After calculating the ratio, now the table shows a whole different picture. Company A seems bigger in terms of its size of operations. This is so because its revenue from operations is higher than Company B. However, if we look from the net profit margin perspective, Company B is better than Company A as the margin ratio is higher. You see? Calculating a financial ratio simply standardised accounting figures and facilitated easy comparison, nullifying the size effect. Although there are many factors for comparing companies within an industry, this example was presented just to understand the relevance of ratio analysis and why we need it. 

But ratio analysis has its limitations, and investors must be aware of them: 

• Financial ratios are not helpful when viewed in isolation. They are only informative compared to other firms or the company’s past performance.
• Comparisons with other peer companies are difficult if there is a difference in accounting treatments. For example, compare an Indian firm with a US firm. 

• It is difficult to find a standard comparable industry ratio when analysing companies that operate in multiple industries [conglomerates].
• Conclusions cannot be made by just calculating a single ratio. All ratios must be viewed relative to one another.
• Determining a ratio's target or comparison value is complex, requiring some range of acceptable values.

Also, although investors get ratios readily available on various websites, it is essential to note that the definitions of ratios can vary widely among the analytical community. 

For example, some analysts use all liabilities when measuring leverage, while others only use interest-bearing obligations. Consistency is paramount. Analysts must also understand that reasonable values of ratios can differ among industries.

How To Apply the Ratios?

The ratio analysis approach compares a stock’s ratio to a benchmark of the ratio. Benchmarks of the ratio can either be their historical value of the ratio under study or peer value. 

The following steps can be used to apply ratio and arrive at a decision making. 

Step 1: Select and calculate the ratio that will be used. 

Step 2: Select the benchmark and calculate the mean or median of its multiple over the group of comparable stocks. 

Step 3: Compare the stock’s ratio multiple to the benchmark. 

Step 4: Examine whether any observed difference between the stock and the benchmark ratio is explained by the underlying determinants and make appropriate adjustments. 

Let's take an example of the P/E ratio. Frequently encountered P/E benchmarks include: 

• P/E of another company’s stock in a similar industry with similar operating characteristics. 
• Average or median P/E of the peer group within the company’s industry. 
• Average or median P/E for the industry. 
• P/E of an equity index.
• Average historical P/E for the stock. 

Now, let’s dive into this concept further and understand different classifications of ratios. 

Classification of Financial Ratios

Financial ratios can be classified by the type of information about the company they provide:

• Efficiency ratios:

This category includes several ratios that indicate how well a firm utilises various assets, such as inventory and fixed assets. Efficiency ratios are also referred to as asset utilisation or turnover ratios. 

• Liquidity ratios:

Liquidity here refers to the ability of the company to pay short-term obligations as and when they come due.

• Solvency ratios:

They give investors information on the firm’s financial leverage and ability to meet its longer-term obligations as and when they come due.

• Profitability ratios:

Profitability ratios provide information on how well the company is performing on various profitability metrics [operating, gross, net, etc] in comparison to revenue from operations (sales).

• Valuation ratios:

These are financial metrics used by investors to assess the attractiveness of a company's stock in terms of its market value. These ratios provide insights into how the market values a company relative to its earnings, sales, book value, and other financial metrics.

It is important to note that these categories are not mutually exclusive. For example, an activity ratio such as payables turnover may provide additional information about a company's liquidity. There is no one standard set of ratios for financial analysis. Different investors use different ratios and different calculation methods for similar ratios. Some ratios are so commonly used that there is very little variation in how they are defined and calculated. 

In the chapter ahead, we will cover some of the most prominent ratios under the above-mentioned classifications. Also, towards the end of every classification, we will have an actual numerical example to show calculations and, most importantly, analysis and interpretation of the ratio.