Ratio analysis is a financial analysis tool used to evaluate the financial health of a company. It is a technique used to compare different financial aspects of a company and evaluate various aspects of its performance. Ratio analysis has its roots in the early days of accounting when merchants would compare the ratios of their profits to their expenses to determine the health of their business. Over the centuries, ratio analysis has been used by investors, analysts, and other financial professionals to gain insight into the financial performance of companies. Check more information about cbap training at adaptiveus e-learning.
In the early 1900s, ratio analysis was used by stock analysts to identify undervalued stocks. By comparing the ratios of different stocks, analysts could determine which stocks had the potential for higher returns. Over time, ratio analysis became a standard tool for financial analysis.
Today, ratio analysis is used to assess the liquidity, profitability, and efficiency of companies. It is also used to compare different companies, industries, and markets. Ratios can help investors identify potential investments, determine the value of a company, and assess the health of a company’s finances.
Advantages of Ratio Analysis as a Strategy analysis technique
- Provides a comprehensive view: Ratio analysis gives a comprehensive view of the financial performance of a company as it takes into account all the financial aspects of a business, such as liquidity, profitability, solvency, and efficiency.
- Easy to understand: Ratios are relatively easy to understand and interpret, even for someone with limited financial knowledge.
- Helps in comparison: Ratios can be used to compare the financial performance of a company to that of its peers or industry averages. This helps in identifying the strengths and weaknesses of the company and helps in making informed decisions.
- Helps in forecasting: Ratios can be used to predict the future performance of a company by analyzing the trends in past financial data. Download business analyst interview questions here for free
- Helps in decision-making: Ratios can be used to assess the performance of a company and to make informed decisions regarding investments, operations, and strategies.
Weaknesses of Ratio Analysis as a strategy analysis technique
- Ignores Qualitative Factors: Ratio analysis only focuses on quantitative factors and ignores any qualitative factors, such as brand reputation, customer service, and employee morale which can have a major effect on a company’s performance.
- Can be Misleading: Ratios can be easily manipulated by companies to make their performance appear better than it actually is, making it difficult to trust the results.
- Difficult to Compare Companies: Ratio analysis can be difficult to compare across companies due to different accounting standards and reporting methods.
- Does Not Measure Future Outlook: Ratio analysis does not provide any indication of future performance, as it only analyzes the past performance of a company.
- Can be Time-Consuming: Ratio analysis can be time-consuming, as it requires a lot of data to be collected, analyzed, and interpreted.
Relationship of Ratio Analysis with other strategy analysis techniques
Ratio analysis is often used in conjunction with other strategy analysis techniques such as SWOT analysis, Porter’s Five Forces, and PEST analysis. Ratio analysis helps to identify the strengths, weaknesses, opportunities, and threats of a company by looking at the financial performance of the company over time. This can be used to help identify the key performance indicators that need to be improved and the areas of the business where investment is needed. It also allows managers to compare the performance of the company against competitors, helping them to make decisions about pricing, product development, and marketing. Furthermore, ratios can be used to assess the financial health of a company, helping to identify potential risks and opportunities for the company.
Future of Ratio Analysis as a strategy analysis technique
Ratio analysis is a powerful tool for strategy analysis, but its use is changing. Companies are increasingly turning to non-financial indicators such as customer experience, employee engagement, and supplier relations to gain insights into their performance. The future of ratio analysis as a strategy analysis technique lies in its ability to incorporate these non-financial data sources in order to provide a more comprehensive picture of the company’s performance. In addition, the use of artificial intelligence and predictive analytics will become a more important part of ratio analysis as these technologies become more commonplace. This will allow companies to better predict future performance and make informed decisions about their strategy.
Ratios assess business performance at strategic and operational levels. It is used to evaluate a number of issues with an entity, such as its liquidity, efficiency of operations, and profitability.
Comparing ratios for previous periods will help in deriving trends, patterns, and insights into company performance. Ratio analysis enables analysts outside the organization to get a good understanding of the financial state of a business. Ratios are usually only comparable across companies in the same sector since an acceptable ratio in one industry may be regarded as too high in another.
There are several possible ratios that can be used for analysis, but only a small core group is typically used to gain an understanding of an entity. These ratios include:
Liquidity Ratios: Ratios that show the relationship of a firm’s cash and other current assets to its current liabilities
- Current ratio: Calculated by dividing current assets by current liabilities. Indicates the extent to which current liabilities are covered by those assets expected to be converted to cash in the near future. It is normally between 1.5 and 2. If it is less than 1, current liabilities exceed current assets, risking insolvency.
- Quick ratio: Calculated by deducting inventories from current assets and then dividing the remainder by current liabilities. This normally lies between 0.7 and 1. If it exceeds 1, it means the quick assets exceed the current liabilities and that the business is safe.
Asset management ratios: A set of ratios that measure how effectively a firm manages its assets.
- Inventory turnover ratio: This ratio is calculated by dividing sales by inventories
- Days sales outstanding: This ratio is calculated by dividing accounts receivable by average sales per day. It indicates the average length of time the firm must wait after making a cash sale before it receives cash.
- Fixed assets turnover ratio: The ratio of sales to net fixed assets.
- Total assets turnover ratio: This ratio is calculated by dividing sales by total assets.
Debt management ratios: A set of ratios that measure how effectively a firm manages its debt.
- Debt ratio: The ratio of total debt to total assets
- Times-Interest-Earned (TIE) ratio: The ratio of earnings before interest and taxes (EBIT) to interest charges-a measure of the firm’s ability to meet its annual interest payments.
Profitability ratios: A set of ratios that demonstrate the impact of liquidity, asset management, and debt on operating results.
- Operating margin: The ratio measures operating income, or EBIT, per dollar of sales; it is calculated by dividing operating income by sales
- Profit margin: The ratio measures net income per dollar of sales and is calculated by dividing net income by sales
- Return on total assets: The ratio of the net income to total assets
- Basic Earning Power Ratio: The ratio indicates the ability of the firm’s assets to generate operating income. It is calculated by dividing EBIT by total assets.
- Return on common equity (ROE): The ratio of net income to common equity; measures the rate of return on common stakeholders’ investment.
Market value ratios: Ratios that relate the firm’s stock price to its earnings and book value per share.
- Price/Earnings ratio: The ratio of the price per share to earnings per share. Shows the dollar amount investors will pay for $1 of current earnings.
- Market/Book ratio: The ratio of a stock’s market price to its book value
Investors and analysts utilize ratio analysis to assess the financial health of companies by analyzing past and current financial statements. Comparative data can show how a company’s financial status or performance has changed over time and can provide an early warning of a prospective improvement or deterioration in the company’s financial situation or performance.