What is Ratio Analysis? Learn Types of Ratio Analysis and Formulas

Ratio analysis is a financial tool used to evaluate a company’s performance by analysing various financial ratios derived from its financial statements. It helps investors, analysts and management assess profitability, liquidity, efficiency and solvency making it easier to compare companies and track financial health over time.

What is Ratio Analysis?

Ratio analysis meaning refers to the process of evaluating a company’s financial performance by interpreting data from its financial statements. It involves calculating ratios such as profitability, liquidity and solvency to gain insights into the company’s overall health, operational efficiency and future prospects.

How Ratio Analysis Works

Ratio analysis works by using a company’s financial statements such as the balance sheet and income statement to calculate financial ratios. These ratios help assess various aspects of a company’s performance, including profitability, liquidity, efficiency and solvency. By comparing these ratios to industry benchmarks or past performance, analysts and investors can gain valuable insights into the financial health and operational effectiveness of the business. This analysis supports better decision-making for stakeholders helping them understand strengths, weaknesses and potential risks.

Importance of Ratio Analysis

Ratio analysis is important because it helps investors and analysts assess a company’s financial performance in a clear and structured way. It simplifies complex financial data, making it easier to understand profitability, liquidity, solvency, valuation and efficiency. By comparing ratios with industry peers or historical trends, investors can identify strengths, weaknesses and growth potential.

• Simplifies financial data: Converts complex financial statements into easy-to-understand metrics.
• Assesses profitability: Helps evaluate how effectively a company generates profit.
• Measures financial health: Shows the company’s ability to meet short-term and long-term obligations.
• Supports stock comparison: Enables comparison with industry peers or benchmarks.
• Assists in investment decisions: Guides investors in selecting financially sound companies.
• Identifies trends: Tracks a company’s performance over time for better forecasting.
• Evaluates valuation: Helps determine if a stock is underpriced, overpriced or fairly valued.
• Analyses operational efficiency: Shows how well a company uses its assets to generate revenue.

Types of Ratio Analysis and Formulas

Ratio analysis is divided into five main types, each serving a specific purpose in evaluating a company’s performance. Profitability ratios assess how efficiently a company generates profit while liquidity ratios measure its ability to meet short-term obligations. Solvency ratios focus on long-term financial stability and debt levels. Valuation ratios help determine if a stock is fairly priced in the market and turnover ratios analyse how effectively a company uses its assets to generate revenue.

1. Profitability Ratios

These ratios gauge a business’ ability to generate profit relative to its revenue, assets, equity, etc. These ratios provide insight into how efficiently a company uses its resources to generate profit.

Some of the most used profitability ratios are:

• Return on Assets (ROA) formula = Net Income/Total Assets x 100
• Return on Equity (ROE) formula = Net Income/shareholders’ equity x 100
• Return on capital employed (RoCE) formula = Earnings before profit and tax / capital employed
• Profit margin formula = Profit/Revenue x 100

The higher the ratio the better. However, the true value of these ratios is obtained when compared with peers, its own historical performance, or the industry average.

For example, an ROE of 20% may sound great. But it doesn’t look as appealing if the peers in the industry in which our focus company operates in has a standard ROE of 25%. Investors can use the SIP Calculator to project investment outcomes alongside these ratios.

2. Liquidity ratios

These ratios measure a company’s ability to meet its short-term debt obligations without the need to raise additional capital. These ratios provide insight into economic health.

In liquidity ratios, the denominator is usually current liabilities, while the numerator is short-term assets.

Higher the value of the ratios the better the company’s financial health.

Some of the most used liquidity ratios are:

• Current ratio formula = Current Assets/Current liabilities
• Quick ratio formula = Current Assets – Inventories/Current liabilities
• Cash ratio formula = Cash and cash equivalents + short term investments/Current liabilities

3. Solvency ratios

While liquidity ratios measure a company’s ability to pay only the short-term debt solvency ratios measure its ability to meet all its short term and long-term financial obligations. These ratios tell us how much capital has come into the company in the form of debt.

Solvency ratios are popular among fundamental analysts as it gives important information about the company’s debt, its capital structure and how it uses debt to finance operations.

Some of the most used solvency ratios are:

• Debt ratio formula = Total Liabilities/Total Assets
• Debt-to-Equity (D/E) ratio formula = Total Liabilities/Shareholders’ equity
• Interest Coverage ratio formula = EBIT/Interest expenses
  *EBIT = Earnings before interest and tax

4. Valuation ratios

Fundamental analysts use these rations to evaluate the prevalent market price of stocks to determine whether they are under-priced, fairly priced or over-priced. A Mutual Funds Return Calculator helps investors estimate potential returns effectively.

Valuation ratios can also be used to compare stocks with peers, industries or benchmarks.

Some of the most used valuation ratios are:

• Price-to-Earnings (P/E) Ratio formula = Share price/Earnings per share
• Price-to-Sales (P/S) Ratio formula = Share price/Sales per share
• Price-to-Book (P/B) Ratio formula = Share price/Book value per share
• Dividend yield ratio formula = Dividend per share/Share price x 100
• Dividend payout ratio formula= Dividend paid/Net Income x 100

5. Turnover ratios

These ratios measure the efficiency of a company in utilising its assets for generating cash and revenue. Fundamental analysts use these ratios to evaluate a company’s performance over time or to measure it against industry peers. Some of the most used activity ratios are:

• Asset turnover ratio formula = Net Sales/Average total assets
• Inventory turnover ratio formula = Cost of goods sold (COGS)/Average inventory
• Receivables turnover ratio formula = Net credit sales/Average accounts receivable
• Payable turnover ratio formula = Net credit purchase/Average accounts payable

Example of Ratio Analysis

Let’s assume you are evaluating Company A to decide whether it’s a good investment opportunity. You perform a ratio analysis using its latest financial statements and compare the results with industry averages and key competitors.

1. Return on Equity (ROE) = 18%

• Formula: Net Income / Shareholders’ Equity × 100
• This means Company A generates ₹18 in profit for every ₹100 of shareholders’ equity.
• Interpretation: A healthy ROE shows that the company is using investors’ funds efficiently. If peers are averaging around 15%, Company A is outperforming.

2. Current Ratio = 2.5

• Formula: Current Assets / Current Liabilities
• The company has ₹2.50 in current assets for every ₹1.00 in short-term liabilities.
• Interpretation: This indicates strong liquidity and the ability to easily meet short-term obligations. A ratio above 1 is generally good, above 2 may suggest excess idle assets.

3. Debt-to-Equity Ratio = 0.6

• Formula: Total Liabilities / Shareholders’ Equity
• For every ₹1 of equity, Company A uses ₹0.60 of debt.
• Interpretation: A moderate level of debt indicates financial stability. If competitors have a D/E ratio above 1, Company A is relatively less risky.

4. Price-to-Earnings (P/E) Ratio = 15

• Formula: Share Price / Earnings Per Share (EPS)
• Investors are willing to pay ₹15 for every ₹1 of the company’s earnings.
• Interpretation: If the industry average P/E is 20, the stock may be undervalued, assuming similar growth potential.

5. Inventory Turnover Ratio = 6 times

• Formula: Cost of Goods Sold / Average Inventory
• The company sells and replaces its inventory 6 times a year.
• Interpretation: A good indicator of efficient inventory management. If the industry average is 4 times, Company A is performing better.

Final Insight

From this ratio analysis, Company A appears to be:

• Profitable (high ROE),
• Financially stable (low D/E and strong current ratio),
• Efficient (good inventory turnover), and
• Possibly undervalued (lower-than-average P/E).

This structured analysis helps investors decide if the stock aligns with their risk and return expectations.

Advantages of Ratio Analysis

Ratio analysis offers a practical way to understand a company’s financial health and performance using data from its financial statements. It simplifies complex numbers, making it easier for investors, analysts, and business owners to evaluate profitability, liquidity, efficiency, and risk. By comparing ratios over time or against industry benchmarks, stakeholders can make better-informed decisions related to investments, lending or internal improvements.

• Simplifies financial data for easy interpretation and analysis.
• Evaluates company performance across key areas like profitability, liquidity and solvency.
• Assists in investment decisions by comparing companies and identifying strong performers.
• Identifies strengths and weaknesses within the financial structure.
• Tracks trends over time to assess growth and operational consistency.
• Enables benchmarking against industry peers and past performance.
• Useful to various stakeholders including investors, lenders, and company management.
• Speeds up decision-making with clear financial indicators.

Disadvantages of Ratio Analysis

While ratio analysis is a helpful tool it also has limitations. It relies heavily on historical data, which may not reflect the company’s current or future performance. Ratios can also be misleading if the financial statements used are inaccurate, manipulated or outdated. In addition comparing ratios across industries or companies with different accounting policies can result in incorrect conclusions. Therefore, ratio analysis should be used with caution and alongside other evaluation methods.

• Based on historical data that may not reflect future performance.
• Can be misleading if financial statements are inaccurate or manipulated.
• Lacks standardisation across companies with different accounting practices.
• Ignore non-financial factors like market trends, management quality, or brand value.
• Not always comparable across industries with different business models.

How Does Ratio Analysis Help Investors?

Ratio analysis helps investors, analysts, and business owners assess a company’s financial health, performance and efficiency. It supports decision-making by:

• Identifying strengths and weaknesses in financial operations
• Comparing performance over time or with peers
• Helping evaluate profitability, liquidity, and solvency
• Supporting investment, lending or strategic business decisions

What Are the Uses of Ratio Analysis?

Ratio analysis is used to evaluate a company’s financial health and performance. It helps stakeholders make informed decisions based on key financial metrics.

1. Assess Profitability: Understand how efficiently a company generates profit.
2. Evaluate Liquidity: Check if the company can meet short-term obligations.
3. Analyse Solvency: Determine long-term financial stability and debt levels.
4. Measure Efficiency: Track how well resources are utilised.
5. Compare Performance: Benchmark against industry peers or historical data.
6. Support Investment Decisions: Helps investors judge whether a company is worth investing in.
7. Guide Management Decisions: Aids in strategic planning and internal improvements.

Classification of Ratio Analysis

Ratio analysis is broadly classified into five key categories, each focusing on different aspects of a company’s financial performance. This classification helps analysts and investors understand specific strengths and weaknesses in a structured manner.

1. Profitability Ratios

Measure how effectively a company generates profit from its resources.
Examples:

• Return on Equity (ROE)
• Return on Assets (ROA)
• Profit Margin

2. Liquidity Ratios

Evaluate a company’s ability to meet short-term financial obligations.
Examples:

• Current Ratio
• Quick Ratio
• Cash Ratio

3. Solvency Ratios

Assess the company’s long-term financial stability and debt-handling capacity.
Examples:

• Debt-to-Equity Ratio
• Debt Ratio
• Interest Coverage Ratio

4. Valuation Ratios

Help determine whether a company’s stock is overvalued, undervalued, or fairly priced.
Examples:

• Price-to-Earnings (P/E) Ratio
• Price-to-Book (P/B) Ratio
• Dividend Yield

5. Turnover or Efficiency Ratios

Show how efficiently a company uses its assets to generate revenue.
Examples:

• Asset Turnover Ratio
• Inventory Turnover Ratio
• Receivables Turnover Ratio

These classifications allow for a detailed and targeted evaluation of a company’s financial standing.

Conclusion

Ratio analysis is a powerful tool that simplifies financial data and helps assess a company’s overall performance. By examining key ratios across profitability, liquidity, solvency, valuation, and efficiency, investors and analysts can make informed decisions. While it has some limitations, when used alongside other methods, ratio analysis offers valuable insights into a company’s financial health and investment potential.