Why financial ratios are to be analysed?

 

Why financial ratios are to be analyzed?

Credit Image by Pixbay.com

Financial ratios are the indicators of the company's performance and status. So In order to know the health condition of the company, these ratios are calculated because of these calculations 

•          Know about the financial health of the company and also you can compare it with the competitor. This is to understand the sustenance of the business in a competitive world.
•        For the retailer investor, it is always to be aware of the company before investing in the stock.

The financial ratios are divided into 5 categories.

1.       Profitability Ratio

2.       Liquidity ratio

3.       Solvency Ratio

4.       Activity ratio

5.       Valuation Ratio

From all these ratios you can understand the profit margin of the company, short term and long term debt position of the company, operational the efficiency of the company, the share price valuations of the company.

Financial Ratios and Analysis:

1.       Profitability Ratios:

·         How good a company is giving returns on earning?

·          Competitive position of the company in the market.

·         Income statement- Sources of Income and expenses.

Example: Profit Margin = Net profit/Sales Revenue.

2.       Liquidity Ratios:

·         The position of the company: How comfortable the company is to pay debts in the short term.

Example: Current Ratio = Current Asset/Current Liabilities

It is always to better for the company to have more asset value than the current liabilities. This is to pay its short term debt. So that there will not be any risk of the insolvency of the company in the future.

3.       Solvency ratio:

It is like a liquidity ratio but here solvency is considered for long term debt.

·         The position of the company: How the company is to pay debts in long term.

In long term debt, it includes term loan for purchasing the assets for utilization like machinery, infrastructure.

·         Also known as the leverage ratio or Debt Ratio.

Example: Debt ratio = Total Liabilities/Total Assets.

        From this ratio you will understand, how much debt is used to finance its asset. Suppose if the debt ratio is 0.9then 90% of finance is used to purchase it asset which is not good.

So it Is always better to have a low debt ratio so that it will not create any insolvency problem in the future.

4.       Activity ratio:

·         Measures the operation efficiency of the company.

·         How the company utilizes its working capital and long term assets efficiently to produce more.

·         Also known as Efficiency Ratio or asset Utilization Ratio.

Example: Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory For instance let us see the example of any chemical product company

Suppose the production cost of the chemical is 100 Lakhs.

Suppose Average inventory which includes raw material, packing material, etc and its cost is 10 Lakhs.

Then Inventory turnaround ratio = 100/10 =10.

This means 10 times the chemical is being sold in a year. So it is always to higher inventory ratio.

5.       Valuation ratio:

·         Used for investment decision

·         What is the right value of the company

Example = Earnings per share = Net Profit/ No of outstanding shares.

                     P/E ratio = Profit per share/Earning per share.

                Low P/E = fairly Priced = Better for investment.