Ratio Analysis

Ratio analysis is a financial analysis technique used to evaluate the performance of a company
by analyzing various relationships between items on its financial statements. It involves
calculating and interpreting ratios that provide insights into a company's liquidity, profitability,
solvency, and efficiency. Common ratios include:

1. Liquidity Ratios:

These measure a company’s abilities to meet its short-term obligations. Liquidity ratios are
financial metrics used to assess a company's ability to meet its short-term financial
obligations and its overall liquidity or financial health. These ratios are important for both
investors and creditors as they provide insights into a company's ability to cover its
immediate financial needs. There are two commonly used liquidity ratios:

 current Ratio: The current ratio is calculated by dividing a company's current assets by
its current liabilities. Current assets include cash, accounts receivable, and inventory,
while current liabilities include short-term debts and obligations that are due within one
year. The formula is as follows:

Current Ratio = Current Assets / Current Liabilities

A current ratio greater than 1 indicates that a company has more current assets than current
liabilities, suggesting it has the ability to cover its short-term obligations.

 Quick Ratio (Acid-Test Ratio): The quick ratio is a more stringent measure of liquidity
compared to the current ratio. It excludes inventory from current assets because inventory
may not be as easily convertible to cash in the short term. The formula for the quick ratio
is:

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

This ratio provides a more conservative view of a company's ability to meet its short-term
obligations, as it focuses on assets that can be quickly converted to cash.

2. Activity ratios:
It is also known as efficiency ratios or turnover ratios, are financial metrics used to assess
how effectively a company manages its assets and resources to generate revenue and
profit. These ratios provide insights into how efficiently a company is using its assets to
generate sales, collect cash, and manage its inventory. Here are some common activity
ratios:

 Inventory Turnover Ratio: This ratio measures how quickly a company's inventory is
sold and replaced during a specific period. It is calculated as:

Inventory Turnover Ratio = Cost of Goods Sold (COGS) / Average Inventory

 Average Collection Period This ratio indicates the average number of days it takes to
convert accounts receivable into cash. This ratio helps the entrepreneur gauge the
liquidity of accounts receivable or the ability of the venture to collect from its customers

Formula= Account receivable/ average daily sales

3. Leverage ratios

These are financial metrics that assess a company's debt levels in relation to its equity or
assets. They provide insight into the extent to which a company is relying on debt to finance
its operations. Common leverage ratios include:

 Debt-to-Equity Ratio (D/E): This ratio compares a company's total debt to its
shareholders' equity. It indicates the proportion of a company's funding that comes from
debt relative to equity.

Formula= Total liabilities/stockholders equity

  Debt Ratio: This ratio measures the percentage of a company's assets that are financed
by debt. It's calculated by dividing total debt by total assets.

Formula=Total Liabilities/ total assets

These ratios are crucial for investors, analysts, and management to gauge a company's financial
performance and profitability. They help in comparing performance over time, against industry
benchmarks, and against competitors. Keep in mind that the interpretation of these ratios may
vary depending on the industry and specific circumstances of the company. By comparing these
ratios over time or against industry benchmarks, analysts can gain valuable insights into a
company's financial health, performance, and potential risks. Keep in mind that ratio analysis is
just one tool in a broader financial analysis toolkit, and it's important to consider other factors as
well